Beware! Everyone’s expectations of investment returns are way too high

I had a coffee yesterday with Pete Comley, author of a new e-book Monkey with a Pin. You can download the book for free here. And you should. Why? Because it explains to you exactly why neither you nor the fund managers you hire to run your money for you ever seem to make the kind of returns studies show the equity market is supposed to offer.

It all comes down to three clear things: first is lack of skills; second is the fact that average returns are lower than the returns made by any index; and third is the impact of charges.

You’ve heard plenty about the third here over the last few years and you’ve heard a good deal about the first too (suffice it to say that a monkey with a pin pretty much always outperforms both the index and any old active fund manager you care to mention).

But what of the second? Comley takes the FTSE 100 as his example on this. It is made up of the top 100 companies registered for trading in the UK by their market cap. It is weighted dependent on company size – with the result that movements in the share price of a larger company will have more impact on the index than movements in the share price of a smaller company.

The index began in 1984 and every quarter it is reshuffled as weightings change and as companies that have seen their market cap fall leave and those that have seen it grow enter the top 100.

 

Think about this for a second and you will see the problem: the index is arranged in such a way that it perpetually measures only the share price performance of the UK’s top performing companies. Any company with below average performance will soon get relegated in favour of one with above average growth. That gives the index an automatic bias to rise (it is known as ‘survivorship bias’).

The result? “An ever increasing index over time” says Comley. This matters for two reasons. First because it builds in unrealistic expectations of what the ‘average portfolio’ might do. But second because it leads people to think that buying and holding is a better strategy than it really is.

“Say 90% of the top companies in the in the FTSE 100 are going nowhere – their share price doesn’t change over a year. The remaining 10% are rubbish and drop out of the index over a year to be replaced by new companies with rising prices. By the end of the year the index will have risen. But the average price of its original constituents will have fallen.”

Consider the ten-year period from January 2001 to January 2011. Over this period, the FTSE didn’t do much overall (-3%). But 16 of the largest shares declined in price (Marconi even went bust). Had you been invested in them as a buy and holder, you would have lost 1.8% a year, or to put it another way, you would have seen average underperformance against the index of minus 23% on Comley’s calculations.

Regular readers will know that survivorship bias is also rife in the fund management business with rubbish funds regularly shut down or merged with better funds to keep their records out of overall performance data. All things to bear in mind when you are wondering how much you might make in the markets over the next few years – the answer is pretty much always less than the industry says you should.