You’ve heard it before.
Over your lifetime, it’s almost impossible to beat a portfolio of index funds on a risk-adjusted basis.
But when someone says, “Invest with me. You can earn 20 percent per year,” it’s oh-so-tempting.
That’s your test. Could you pass it? Or would you actually give them money?
That was a crucible I failed.
Several years ago, a friend of mine invested in a private firm that said he would earn 4.5 percent per month.
“That has to be a scam,” I said.
“No,” he replied. I’ve been investing with them for a year, and I’ve gained 54 percent. You should invest with them, too.”
“Well, that’s on paper,” I argued. “You haven’t cashed in your original principle, so if this firm goes the way of the Brontosaurus, you might not get the money back.”
“It’s managed by such a brilliant guy,” my friend replied. “I can introduce you to him.” The manager allowed investors to reinvest the profits or take cash (like a dividend) every month. My friend was retired, so he always took the cash.
I was curious enough to meet this guy with a Midas touch, so when my friend arranged a meeting, I met the guy, one-on-one, to learn about his business. And the manager was impressive. In many ways, I was like a five-year-old kid: curious enough to put my hand near the fire, but not dumb enough to burn it. At least, that’s what I thought.
A year later, my friend gained another windfall return. “Sell it all,” I implored. “This isn’t right.”
Why was I sceptical? After all, plenty of billionaires on the Forbes 400 list of richest Americans had to beat the stock market indexes to make that coveted list. If they asked you to invest with them, would you do it? I’m guessing you might be tempted.
Imagine if you were the 400th-ranked billionaire. You decide to sell your billionaire-creating enterprise and invest everything you have in the S&P 500 index. Would you slip from the Forbes 400? Or would you climb that list?
Get your climbing shoes on, because, you my friend, would climb.
The Forbes 400 is a slick rock. Each year, plenty of new people scramble onto that granite and make their way up. Others drop off as their fortunes, luck, and investment acumen fade.
In his book, Tailored Wealth Management, Niall J. Gannon reports that from 1982-2017, those who wanted to maintain a position on the Forbes 400 list needed to grow their wealth by an average of 7.78 percent per year. That sounds easy, right? After all, the global and US stock market indexes both trounced that return over the same time period. But most of the people on the Forbes 400 list fail to replicate high returns.
I should repeat that: most of the investors on the Forbes 400 list were not able to beat the global or US stock market index from 1982-2017.
There’s an important distinction here. Such investors grew their wealth at a rate that beat the stock market index before getting on that list. But most of them couldn’t maintain such a high growth rate. That’s because, beating the index also requires luck. And luck isn’t something you can pour into a bottle and sip whenever you need the stuff. That’s why, if a member of the Forbes 400 (or anyone, for that matter) offered to invest your money and said, “I can earn you 12%, 20% or more,” you would be wise to decline.
But let’s come back to my friend. He gained more than 50 percent per year… for eight straight years. Can you see why I weakened and eventually invested money?
Just a few months later, the clock struck twelve. Horse-drawn carriages and chauffeurs turned back into pumpkins and mice. And I lost every penny I invested with them.
It began, I believe, as a legitimate operation. But the manager soon learned he couldn’t earn the claimed returns. That’s when it morphed into a Ponzi scheme. I wrote about it in Millionaire Teacher.
Statements were doctored. As the manager grew desperate, new money (of which plenty poured in) was used to pay those who received interest or redeemed their investments to buy houses, cars or boats.
Clearly, some managers do get lucky and beat market indexes. But only crooks or fools claim they can do it ahead of time. In other words, if anyone suggests you can earn returns of 12%, 20% or more by investing with them, you’ve found a crook or a fool.
Disgraced hedge fund manager, Bernie Madoff, told his investors they could earn 12 percent per year. Eventually, it caught the attention of the US Securities and Exchange Commission. The regulatory body suspected Madoff because his investors earned solid returns, whether the market or the economy moved up, down or sideways.
Unfortunately, the regulators didn’t step in to shut Bernie down. And when that clock struck twelve, Madoff’s investors lost everything. They included smart people, like Steven Spielberg, and plenty of public and private pension funds.
Over time, diversified portfolios of index funds beat most hedge funds. They beat most private equity firms. They beat most college endowment funds. They beat most actively managed funds. They beat most of the brilliant people on the Forbes 400 list.
So… when faced with someone who says they can earn you 12%, 20%, or more, please just run away.
Time, almost certainly, won’t be kind to those who don’t.
Andrew Hallam is the best-selling author of Millionaire Expat (3rd edition), Balance, and Millionaire Teacher.