Why your returns are a lie

You might have heard that it’s easy to earn 10% per year in the stock market. But, for most investors, those returns are a mirage because a bevy of factors act against them. One of them is simple mathematics.

Let’s start with the good news. The Canadian stock market (as represented by the S&P/TSX Composite index) provided average annual returns of 10.4% from 1970 through 2015.

That’s the market’s arithmetic average annual return. It’s calculated by summing up all of the annual returns generated by the index over the years and then dividing by the number of years in question.

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Problem is, investors don’t get these returns. They get compound (or geometric average) returns instead.

An investor who put $1,000 into the market at the start of 1970 would have found themselves with about $53,000 by the end of 2015. (Provided one ignores extra frictions like commissions, fees, and taxes.) Their portfolio grew by a compound average of about 9.0% annually, which is a good deal lower than the arithmetic average of 10.4% annually.

To see how the difference arises, let’s walk through a simplified example. Suppose you invest $1,000 in a stock that goes up 60% in the first year and then falls 50% in the second.

The simple, or arithmetic, average annual return would be (60% plus -50%) divided by 2. That’s an average annual gain of 5%.

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Now follow the money. The investor starts with $1,000, which grows to $1,600 (a 60% gain) after the first year. It then falls to $800 (a 50% loss from $1,600) by the end of the second year. Overall, the investment lost 20% over 2 years, which is equivalent to an annualized loss of about 10.6%.

In this hypothetical case, the arithmetic annual return is 5% whereas the investor actually lost 10.6% annually (the geometric average).

A similar thing happened for the Canadian stock index which boasts of arithmetic average returns of 10.4% per year from 1970 through 2015 but investors only compounded their money at an average rate of 9.0% annually in practice.

That tricky bit of math is just the start of the problem for investors. For instance, if you adjust for the declining purchasing power of the Canadian dollar over the period (otherwise known as inflation) then the real annual return Canadians got plunges from near 9.0% to just about 4.8%. That’s less than half the 10% advertised rate.

Alas, nasty things like fees, commissions, and taxes also take a big bite out of returns. But I’ll have to take a trip to the doctor for some anti-depressants before adding those to the mix.

Let’s just say that investors are likely to achieve inflation-adjusted returns that are a good deal less than 5% in the future. As a result, they should think about saving a little more and spending a little less than they might have expected.

Safer Canadian Dogs

Investors following the Dogs of the Dow strategy want to buy the 10 highest yielding stocks in the Dow Jones Industrial Average (DJIA), hold them for a year, and then move into the new list of top yielders.

The Dogs of the TSX works the same way but swaps the DJIA for the S&P/TSX 60, which contains 60 of the largest stocks in Canada.

My safer variant of the Dogs of the TSX tracks the 10 stocks in the index with the highest dividend yields provided they also pass a series of safety tests, such as having positive earnings. The idea is to weed out companies that might cut their dividends in the near term. Just be warned, it’s a task that’s easier said than done.

Here’s the updated Safer Dogs of the TSX, representing the top yielders as of March 18. The list is a good starting point for those who want to put some money to work this week. Just keep in mind, the idea is to hold the stocks for at least a year after purchase – barring some calamity.

Source: Bloomberg, March 18, 2016

Notes

Price: Closing price per share

P/B: Price to Book Value Ratio

P/E: Price to Earnings Ratio

Earnings Yield: Earnings divided by Price, expressed as a percentage

Dividend Yield: Expected-Annual-Dividend divided by Price, expressed as a percentage

As always, do your due diligence before buying any stock, including those featured here. Make sure its situation hasn’t changed in some important way, read the latest press releases and regulatory filings and take special care with stocks that trade infrequently. Remember, stocks can be risky. So, be careful out there. (Norm may own shares of some, or all, of the stocks mentioned here.)

Required Reading

How To Beat The S&P 500 Index

Andrew Hallam reports on the Dogs of the Dow’s long winning streak.