What Are Your Actual Returns?

There was some good discussion on my post from last week about the return numbers on the S&P 500 from 1934-1953 (see Stock Market Losses With Low Interest Rates).

A reader made the comment that it was unrealistic to use S&P 500 returns from that time because there were no index funds in existence back then. Index funds didn’t exist until the 1970s. In fact, there weren’t really many mutual funds back then either. As one reader pointed out there were only 50 mutual funds or so in the 1930s.

Something else not many investors realize is that the S&P 500 didn’t even consist of 500 companies until 1957. Before that it was made up of just 90 companies in the railroad, industrial and utility sectors.

Not only were there no index funds, but the commissions were ridiculously high if you would have tried to build your own portfolio of stocks. According to Rick Ferri, if you were to try to buy a single share of every stock in the Dow Jones Industrial Average during the 1950s, commissions would have eaten up over 11% of the purchase price.

So there is some validity to the fact that it would have been nearly impossible to match the market’s return back in the day from the costs and complexity involved. There are two ways to think about this: (1) Historical return numbers should be taken with a grain of salt or (2) It’s now easier than every to earn market returns with little-to-no frictions compared to the past.

Compare the plight of investors trying to build a diversified portfolio in the 30s, 40s or 50s with today’s financial product line-ups and costs. Commissions range anywhere from $9.95 per trade to nothing at most fund firms or brokerages. There are index funds in every market, asset class, risk factor or sector imaginable. And I didn’t even mention the impact of taxes on historical returns. Vehicles such as ETFs now make tax efficient strategies available to all investors, no matter the size of their portfolio.

So while industry observers continue to forecast lower future market returns, it’s possible that investors who are able to behave will be able to earn much higher returns than those in the past on a net basis after all fees and taxes are taken into account. Gross returns on the market may have been higher in the past but part of the reason for that could have been because it was nearly impossible to easily earn those returns. Maybe investors required higher returns to compensate them for those costs.

Now investors can buy the market’s performance, basically for free, but investors continue to be their own worst enemies. This is why we see a persistent behavior gap between fund returns and those earned by actual investors. So past frictions have been erased through competition and technological innovation, but they have been replaced by over-activity and poor decision-making from investors.

I always say historical returns are always a better gauge of possible risks than they are of future returns investors can expect. It’s very easy to look back at past market performance and assume it would have been easy to earn those return numbers. Investors are much better off figuring out ways to earn as much of the performance from the market or fund returns going forward by reducing commissions, fees, taxes and unnecessary portfolio turnover.

The Power of Passive Investing

Further Reading:
On the Merits of Being a Financial Historian
Torturing Historical Market Data

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  1. ST commented on Apr 22

    Ben, you are the first person the financial universe I’ve read who views historical returns as a risk parameter rather than a return parameter. That kind of thinking will get you somewhere. 😉

    Couple points on pre-index returns and markets, the S&P was 90 stocks on the surface but always accumulating towards 500 in the background. So an average retail investor would have been decimated trying to keep up with additions and replacements. As well, in the early years, additions/deletions were not always reported in a swift manner (or at all,), so an “indexer” may have been holding a non-exact S&P portfolio during certain times.

    To comment on commissions, it worked both ways in hampering investors and investments. Low commissions was a big factor in why Vanguard’s first index fund was a flop — the brokers didn’t make any money off the sales so they didn’t sell it! It’s amusing that it took roughly 30 years for the ugly duckling of the market to become everyone’s sweetheart. Not so amusing is how bad the industry fights to keep high fees et al as an easy way to make money instead of actually working for it.

    • Ben commented on Apr 22

      Thanks. The way you framed it sounds much smarter than how I said it. Good point on the build-up of the index. I never thought about it that way but that’s another source of added costs over the years. Once again shows why investors have it so good these days.

      Maybe someone else would have come along, but I’m convinced the fund industry would look completely different today (for the worse) had it not been for Vanguard. A great what if? scenario in my mind.

      You may have already seen this but here’s some more history on the S&P if you’re interested:


  2. Eric commented on Apr 22

    It doesn’t appear to matter much. From 1928-1994, the S&P as we know it today did 9.8%. Over the last 20 years, the Vanguard S&P 500 did +9.7%.

    • Ben commented on Apr 22

      That’s valid. I also thinkg too many of those calling for lower returns in the future fail to look outside of the US when making those predictions.

  3. Jim Haygood commented on Apr 22

    One thing is certain: investors collectively received the market return. But no one used to know what it was. One day in 1959, Louis Engel at Merrill Lynch phoned Professor James Lorie at U. of Chicago and asked what an investor who owned every stock on the NYSE would have made, taking account of corporate events such as mergers, bankruptcies and delistings. Quick on his feet, Lorie suggested that Merrill Lynch fund the study.

    When the first results were announced in 1960, the answer (counting from Dec. 31, 1925) was 9 percent. Did any particular individual or institution actually achieve that return? Almost certainly not, since there were no total return stock funds back then. But 9 percent was the nominal total return that such a fund would have earned.

    Not even the CRSP database presents a full picture, though. Most banks and insurance companies were traded over-the-counter until the late 1960s and early 1970s. But CRSP’s coverage of the OTC (now Nasdaq) begins in Dec. 1972. So big chunks of the financial sector are missing from 1925 to 1972. Banks went from “too obscure to count” to “too big to fail.”

    • Ben commented on Apr 22

      Jim I can always count on you for the historical perspective that I didn’t know. That’s a great story. In many ways it really was something of a Wild West back in the day. Pure speculation, basically, especially in the early 1900s. This is why it pays to be skeptical of perfect back-tests. You always have to do your homework on these things and make sure there’s a legitimate reason that things will work going forward.

    • Liza commented on Apr 25

      Amazing Jim,

      How do you do it

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