Real vs. Imaginary Returns – Part III

“The riskiness of an investment is not measured by beta but rather by the probability—the reasoned probability—of that investment causing its owner a loss of purchasing-power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And a non-fluctuating asset can be laden with risk.” — Warren Buffett, in his 2011 Berkshire Hathaway shareholder letter.

I have a confession to make! I lied to you last week at the end of Part II. But so did all the financial institutions that publish one of those “missing the best days of the market” bar charts.

Let’s go back to the Fidelity study about Chicken Little bailing during the best days in the market. It is true—and stunning—that missing a handful of days materially damages returns, even over the very long term. What is not true is the extent of the damage.

Let’s end this series on a high note: it gets worse! You think those wheelbarrows of fiat currency are going to let you buy the whole dealership instead of just a new car? Think again!

Will Fidelity tell you the whole truth? Vanguard? Nope. Nobody but your friendly neighborhood spreadsheet addict is going to tell you. It reminds me of a story about two astronauts who made it through a meteor shower. After a quick inspection, the engineer says to the pilot: “I’ve got good news and bad news. The good news is we only have a small hole through the hull. The bad news is we’re going through it.”

That little hole in this 37-year study is called inflation. It’s only 2.75% annualized, but you’re going through it.

Pretend you’re human and you read that Fidelity study (or one of the many like it). The story is the same: set your asset allocation strategy and stay the course. Good plan. You start with $10,000 in a low-cost S&P 500 fund, set it up to reinvest dividends, and away you go. Let’s look again at the returns we would have had.

Fidelity Missed Days Chart

Being human, you look at that growth chart and compare the ending amounts to the $10,000 at the beginning. That’s the whole point. And it’s a lie. Apples-to-oranges. You won’t have anywhere near the purchasing power implied by that comparison, but that’s what’s being sold to us. There’s a little hole in your hull that is compounding: the time value of money, present value, real purchasing power vs. nominal illusions.

I reworked the Fidelity bar chart to include real (inflation-adjusted) returns for the fully invested case and each of the “missed days” categories. Apples-to-apples. Annual return percentages are included to help you eyeball the inflation hit. Example: if you stayed in the market, your $10,000 investment grew 19× in purchasing power, not 52×.

Fidelity Missed Days with CPI-Adjusted Values

Because I’m such a great guy, I’ve attached the math so you too can convert make-believe money into real money.

Time Value Math

The beautiful reality behind all of this is that real returns are still very, very good. Appropriate allocation strategies, keeping costs low and spending in check really work—even if we aren’t flying around in private jets.

(Graphs are high-resolution and should be viewed full screen. You can download them.)

Go to Part I

Go to Part II