The Passive Investing 10% Return Myth

Active investing is dead. Well, at least if you read the headlines of most financial news sites. Armed with data to back that the market returns 10% per year over the long-term, investing in a low-cost S&P index certainly seems like a no-brainer.

In fact, according to CNBC, 80% of the stock market is on "auto-pilot", i.e. using either passive management or algorithmic investing. The "buy everything" strategy can be seen everywhere and is pitched to naive investors as a safe way to compound money.

Companies such as Acorns repeatedly cite the myth that a long-term investment
in a passively managed index will grant returns of ~10% per year

One company that I always see ads for (as Google apparently knows I'm a millennial investor) is Acorns. Acorns is an app that claims to round up every purchase you make with a debit card to the nearest dollar (which on average is a mere 50 cents per purchase) and place it into a passively managed S&P 500 index fund. The website then explains that the S&P index fund has returned 10% per year on average since the late 1920s (with the implication that this will continue into the future).



Something didn't seem right to me. If one can receive 10% per year relatively risk free (by diversifying and holding over a long period of time), why would anybody have their money anywhere else? It certainly beats the returns on bonds or a high yield savings account. Plus, it has the added benefit of massive liquidity, so investors of any size can put their capital in a passively managed fund.

I decided to go ahead and "fact-check" the 10% per year claim, which was conveniently hyperlinked. To my dismay, it cited another article on the same Acorns site.

Clicking the hyperlink on that article returns a third article from the Acorns website.

Finally, the link on this page brings me to a CNBC article.

Unfortunately the article has no citation or evidence for a 9.8 percent return. Oh well.

The good news is that the S&P pricing data is readily available online, so we can calculate the average return ourselves. The S&P traded at 26.19 on average during 1929. Using excel, we can calculate the average compounded annual return.

The compounded return from 1929 to today was 5.43%. If we give CNBC the benefit of the doubt, we can assume their estimate of 9.8% is true when we include reinvested dividend payments (as dividends have averaged somewhere between 4% and 5% over this period). 

However, if we take a look at GDP growth during the same period, we can see it is almost identical to the return on the S&P (GDP is in billions).

This means that over the long-term, the market capitalization of the S&P has tracked GDP. Total return therefore has roughly equaled GDP growth + dividend rates over the long term (which is roughly the "Gordon Equation"). Going forward, with roughly 3% per year of GDP growth and a 2% dividend rate on the S&P, expected long-term future returns are around 5%, not 10%.

This of course does not take into account other factors such as poor investor timing, taxes, inflation, and any other costs associated with investing. If we include taxes, the 5% return becomes a 4% return after tax (using the 20% long-term capital gains rate). On top of that, with an estimated 2% inflation rate going forward, our after-tax, after inflation real returns are a mere 2% per year. The 2% per year is a best case scenario as it is impossible to quantify the costs of other investor errors, such as timing.

If we look at the modern era, we can visualize how timing harms investors.

(the first peak is 1999, the second is 2008)

If an investor had invested in the late 1990s (and assuming they didn't sell during the dot-com burst), they would have had no capital gain returns until around 2013. No returns in 15 years is a certainly not what people would expect after telling them their money would double roughly every 7 years (10% growth). Although the returns from 2008 to 2019 have been better, I imagine we are near the end of the cycle. This means that investing in an index today could potentially lead to a decade and a half of stagnation.

This article is not meant to scare investors away from stocks; I think there is still value to be found in the markets. However, in the near future I believe the tables will turn and active investing will once again beat out passive. The goal of active investing is largely to protect downside, so without a major decline in a decade most actively managed funds are under-performing the market. It will certainly be interesting to see if investors will return money to active management after the next major recession.

Between an expected gross long-term return on the S&P of only 5%, investing at all time highs, and joining the crowded passive index investing trade, I believe placing money into an index fund is a grave mistake in 2020.