Oh Dear…..Part One

I actually saw this article the other day whilst having breakfast after training. The opening point so caught my eye that I had to find the original source article and see if it was correct – my looking over someones shoulder guess was that is was not. The article begins with a somewhat staggering claim and as they say extraordinary claims require extraordinary proof.

Investing in shares can be a wonderful way to build a nest egg for your retirement. You’re taking a part-ownership in real businesses, whose directors and managers spend their time trying to make you more money – and who often give you a six-monthly dividend payment for the privilege.

How good can it be? Consider a hypothetical investment in the companies that make up the All Ordinaries index. $10,000 invested in 1984 was worth a cool $278,000 in 2014, even if you never added another dollar. That’s a very nice return for in effect doing nothing but waiting. Adding just a small amount each month would have seen you with a very nice seven-figure sum. How many other “do nothing” strategies offer you a million-dollar pay day?

If I’ve got your attention – and I hope I have – here’s how to get started:

Scott Phillips – Motley Fool

It got my attention because I think the claim is wrong and I have not been able to reproduce it. I fired up excel and I dropped $10,000 into the All Ordinaries index .Remember the claim is that you have bought the shares that make up the All Ords therefore your portfolio will completely match the performance of the index (there is a problem with this idea but more on that in a moment.) My $10,000 investment by yesterdays date had grown to $70,258.79 – you will agree this is a l0ng way shy of the reported $278,000. You can see the trajectory of the equity curve below. Note, an equity curve is the only honest way to talk about and to illustrate returns. Take note of this point because I will return to it.

When I looked at this I thought maybe the figure was generated by taking the long term rate of return of the index and simply multiplying $10,000 by this figure. Using 1984 as my starting point 1 worked out that the average annualised rate of return for the index was 6.8%. The rate of return needed to turn $10,000 into $278,000 is 11.72%pa. However, remember the point I made about equity curves – an equity curve is a true measure of the trajectory of equity generating by actually trading a given system. In this instance I assumed the system was simply a passive investment in the All Ords Accumulation Index. Taking the yearly return for the All Ords Accumulation Index through to June 2014 I generated the equity curve below.

With a terminal equity of $209203.55 we are closer but we have still missed the mark by quite a way. There is a substantial difference between $278,000 and $209,203.55. The take home point from this part of the examination is that simply projecting future returns based upon an average number is bollocks. To give you a simple example of why this is so consider the following puzzle. If I invested in a fund on day one of year one and the fund returns 100% for that year and then at the end of year two has lost 50%. What is my average annualised rate of return?  The answer is (100%-50%)/2 = $25%.

So if I had invested $100,000 how much money have I made?

You have made zero. Your money doubled in the first year and then halved in the second year – you are back to where you started but if I were running this fund I could claim that my average rate of return was 25%pa. This is why average rates of return are a trap for the unwary and present an extraodinarily naive view of how markets and investing actually work and as such they need to be viewed with extreme scepticism

The article also presents other problems which I would look at in part tomorrow.