Big Retirement Problems: How Investment Research is Setting you up for Failure

When research says "the market returned 10% over 80 years," what does that actually mean for your retirement? Most DIY investors make critical assumptions about expected returns that create serious retirement planning problems.

This episode breaks down the troubling gap between advertised fund performance and real investor results. We examine research from Dalbar and Morningstar showing retail investors consistently underperform stated returns by 1-2% annually—which can mean missing out on 15-50% of potential gains depending on the asset class.

You'll learn why compound annual growth rate (CAGR) calculations don't reflect your actual experience as a periodic investor, how behavioral mistakes like panic selling and performance chasing sabotage results, and why social media success stories create dangerously unrealistic expectations.

Most importantly, we explore practical solutions: understanding money-weighted returns, accepting realistic performance gaps, focusing on adequate savings over chasing returns, and why income-focused investing shifts the conversation from rates of return to sustainable retirement cash flow.

Chapters:

[00:00] Introduction: The Return Gap Problem
 [01:10] The 15% Fund Paradox: Why Your Results Differ
 [03:27] Dalbar Research: The Disappointing Truth
 [06:18] Morningstar's Findings: Missing 15% of Returns
 [07:58] CAGR vs Money-Weighted Returns Explained
 [11:09] The Rebalancing Drag Effect
 [15:25] Behavioral Mistakes: Fear & Performance Chasing
 [24:31] Social Media's Distortion of Expectations
 [25:53] Practical Solutions for Realistic Planning
 [27:43] Income-Focused Investing: A Different Approach
 [29:27] The "Saving Too Much" Question Answered

Transcript

00;00;20;15 - 00;00;47;21
Brandon
You are listening to the Yield to Reason podcast, where we help you build a bulletproof retirement portfolio with a keen eye on investment income, because independent wealth hinges on your ability to pay the bills. We are dedicated to solving Retirement's biggest riddle how to turn your hard earned savings into spendable cash so you can enjoy the retirement you actually want, and make it the retirement you truly deserve.

00;00;47;24 - 00;01;10;07
Brandon
I am Brandon Roberts. Thanks so much for joining me today. As we dive into a lot of investment research and ask a very serious question, is it causing you to make big planning mistakes about retirement? When you see a statistic like the quote unquote market returned 10% over the past 80 years, what does that practically mean for you?

00;01;10;10 - 00;01;35;08
Brandon
A lot of people make a wide array of assumptions about what that statement means and what they will be able to do with it, and it's causing some big problems when it comes to retirement preparedness. So imagine that you are investigating various investment options, and you stumble upon a mutual fund that reports that over the last 20 years, it has returned 15%.

00;01;35;11 - 00;01;57;25
Brandon
Sounds really good. You decide this is totally worth it and you invest $20,000. A year later, you put another $10,000 into it. And then the year after that, you add an additional $20,000 to your investment. After you've owned this fund for five years, you look at your rate of return and find out that it's only 8%, and you're a bit curious as to why your results differ so dramatically.

00;01;57;28 - 00;02;45;27
Brandon
You kind of wonder, maybe this is one of those situations where past performance doesn't guarantee future results, but then you look at the fund literature and discover that the fund itself is still advertising a 15% rate of return over the past 20 years, which are current dated. What on earth is going on? There are a few different possible explanations, but before we get into that, we're going to talk about the various attempts to quantify and identify real market returns versus what real retail investors achieve in their investments, and explain why they vary so considerably, because numerous things are unfolding all at the same time, and they actually compound to create real results that are dramatically

00;02;45;27 - 00;03;27;03
Brandon
different from headline advertised achievements that mutual funds and indexed funds and various professional investors achieve, and even, somewhat nonprofessional investors achieve as they go out and try to make money on the market. So for several years now, there has been an analysis performed by Dow Bar called the Quantitative Analysis of Investor Behavior. And it looks at what real retail investors are likely achieving in various investments broken down by asset class.

00;03;27;06 - 00;04;11;28
Brandon
So this looks at how equity investors performed, how bond investors perform and compares it to various benchmark indices. That would be indicative of doing at least as well as the broad market did. And the Dow Bar Research has largely shown disappointing results when it comes to the real performance of retail investors. In fact, the last annual update to the quantitative analysis of investor behavior showed us that one year rate of return results for equity investors was 16.54%, which is not bad at all.

00;04;12;01 - 00;04;45;27
Brandon
But the S&P 500 returns something like 25% in that year. So there's a considerable gap between what the average retail investor who is was investing in equity, a broader market equity index funds was achieving, and what you would have gotten simply being in the S&P 500. Now, longer term, the results do converge considerably. The 20 year result for average equity fund investor is just about 9.25% annualized.

00;04;46;00 - 00;05;18;22
Brandon
The S&P 500 would have performed more like ten and a third percent. So the 1.1% ish difference between average equity fund investor and what the S&P 500 accomplished. Not a huge difference. But if we want to talk about real dollars for just a minute, if you would put $10,000 per year into the average equity fund, according to Dial Bar, 20 years later, you'd have about $526,000.

00;05;18;24 - 00;05;42;09
Brandon
If you could achieve over that same 20 year period with the same $10,000 per year investment. What the S&P 500 all on its own did you'd have something like $596,000. So about a $70,000 difference between what the average equity fund investors accomplishing, according to Dow Bar, and what the S&P 500 would deliver you if you were just passively indexed investing.

00;05;42;11 - 00;06;18;06
Brandon
Now, Dow Bar is not alone in terms of research that shows us real investment results from retail investors differ from what we think the regular result is, either by looking at something like the S&P 500 or more or more specifically, individualized funds. Morningstar's Mind the Gap analysis looks at how retail investors perform relative to the stated returns of a broad array of funds, and what they have found is across the board, there's about a 1.2% gap in annual return between stated fund performance and retail investor performance.

00;06;18;06 - 00;06;52;20
Brandon
That doesn't sound like a lot, but the the kind of net result of that for the investor is missing out on roughly 15% of the overall return of the fund. That's that's considerable as the amount invested grows larger. And the interesting piece to the Morningstar research shows us that the lower the expected rate of return, the more of the fund's return is being missed, even when the gap, as expressed as a percentage return, kind of stays consistent.

00;06;52;26 - 00;07;33;22
Brandon
So bond fund investors accomplished, or excuse me, experienced a gap that was 1.3%. So not that much different than the overall average, but they only accomplished roughly 50% of what the fund's stated annual return was. So the research clearly shows us retail investors are not typically accomplishing the, statistic return that we often hear discussed, either by mutual funds that are trying to market themselves or by financial media as it tries to convince people that investing in the market is the way to go, because you can accomplish a certain rate of return.

00;07;33;25 - 00;07;58;08
Brandon
Why? Why are these things different? There are several explanations, but one of the first ones to get into is quite technical, and it has to do with the difference, with regard to measuring rate of return based on how an individual is is actually investing in various funds, be they mutual funds or exchange traded funds. Doesn't really matter in this situation.

00;07;58;11 - 00;08;22;22
Brandon
So most funds will report the compound annual growth rate of the fund. They do that by picking some initial investment amount and then calculating what the growth of the investment was over some period of time. Could be five years, could be ten years, could be 20 years. But what they are assuming is that the investment is going to be made entirely at the beginning.

00;08;22;24 - 00;09;08;11
Brandon
That is not how most retail investors invest, because they don't have all of the money that they're going to be investing from the very beginning. They instead will be investing periodically over time, making additional contributions to their investment. This approach requires an entirely different analysis when it comes to rate of return accomplished, and that is what we call money weighted rate of return takes into account the cash flows, the money coming in, and it can even take into account the money coming out of an investment to arrive at what the actual rate of return is for the individual, and in most cases, the money weighted rate of return as a percentage will be a number

00;09;08;11 - 00;09;31;08
Brandon
that is less than the compound annual growth rate. This happens in large part because if you can invest all of your money right at the beginning, you're going to capture all of the movement in the investment. But if you have to make periodic investments, then you're not going to get at all of the rate of return, because not all of the money was in the investment for the entire period that you're analyzing.

00;09;31;11 - 00;09;53;11
Brandon
The big problem comes up when people are going to be making systematic investments, but they want to project where they think their account balances are going to be, say, in 20 years. And they use something like the result of compound annual growth rate and apply it to their should be money weighted rate of return situation, which grossly overstates their account balance 20 years from now.

00;09;53;14 - 00;10;21;25
Brandon
Now the really important thing to understand is nothing is wrong with respect to the investment itself and the fact that compound annual growth rate and money weighted return are going to be different numbers. The results are just the results. The important piece is understanding which investment approach you are taking out of necessity, and applying the correct number for the correct analysis to arrive at a reasonable account balance projection some point into the future.

00;10;21;28 - 00;10;45;03
Brandon
So if you're going to be making systematic investments, you need to figure out what the money weighted return of your investment is in order to make an accurate projection moving forward. On what your account balance might be. If you're in a position where you've got all the money that you're going to put in the fund right now, and you're not going to make any future contributions, then the compound annual growth rate, which will almost always be on the marketing brochure, is the number that you can use to estimate what future values might be.

00;10;45;05 - 00;11;15;10
Brandon
And this confusion between money weighted rate of return and compound annual growth rate is exactly what I was hinting at in our initial example with the fund that performed 15% for 20 years. The fact of the matter is, you didn't put all $50,000 you're going to invest into the fund. In year one. You made systematic, differing investment amounts and found out that some years later, your results differed not because the fund did anything differently and performed any differently, but because your investment contributions happened differently from the analysis in the brochure.

00;11;15;13 - 00;11;54;09
Brandon
But there are other factors that build into the results reported by Dow, Bar and Morningstar, and they have to do with timing. So if you invest in a fund or any style investment at the exact same time that whatever analysis reports a certain rate of return worked out to be, your results should be identical. But most of us will not invest in a fund at the exact same time as everybody else, which means our results are going to be different.

00;11;54;12 - 00;12;24;27
Brandon
Most investment performance that is reported by a fund run a calendar year as their start and end point. So January 1st and then running out December 31st to whatever year it is into the future. For however many years we're analyzing, most people are not going to make their investment under that same timeline. So the results that they will achieve are going to be different because they will be investing at different times, at different times of the year.

00;12;25;00 - 00;13;00;09
Brandon
There are a number of investment newsletter services that are out there that will give their subscribers buy and sell alerts as they analyze the markets and choose various investments that they think are good or bad, and a lot of frustration that former or even current subscribers often voice about the services is their results differ from the stated results that the service boasts when it says, hey, we bought Microsoft here and we sold it at this gain, or we bought Google here and sold it at that gain.

00;13;00;15 - 00;13;43;20
Brandon
And the reason that the subscribers get different results is because they typically can't invest at the same time that the service does, because they don't receive the buy alert at the exact same time that they execute that by purchase the subscriber that the service does. So there's always going to be a bit of a lag in terms of when the subscribers get in versus when the the service gets in, and that is going to change the real results that subscribers achieve, sometimes in a way that is still good for the subscribers to pay for the subscription service, but sometimes dramatically enough, different that their results turn into losses.

00;13;43;22 - 00;14;08;27
Brandon
And of course, psychology plays a big role when it comes to one's willingness to stick with a plan. When things get volatile. We know from research that volatility causes a lot of panic selling at the exact wrong time. For a number of retail investors and interestingly, this volatility is identical when it comes to mutual funds and exchange traded funds.

00;14;08;29 - 00;14;49;08
Brandon
This is a very bizarre phenomenon because you'd think mutual funds, which only clear in terms of price once a day, would have a sort of blunting effect on volatility, because you can't log in to your brokerage account at noon and see what your mutual fund share price is at. Like you can an exchange traded fund, but the research tells us, nope, there's no difference if if there's high volatility in a mutual fund or a high or high volatility in an ETF that tends to have the same negative consequences in terms of of divergence of funds, annually reported rate of return versus what retail investors achieve, because there's way too much panic movement from retail investors

00;14;49;14 - 00;15;34;03
Brandon
as prices whip back and forth. Now, additionally, the research that tries to figure out what the typical rate of return by investing in the market will be has also led, at times, to some highly inflated expectations among retail investors. And this is a especially bad when we have good market years. So research from the Texas Wealth Management shows us that the average retail investor currently expects to achieve a rate of return of 12.6%, net in the market, so 12.6% above whatever the inflation rate is.

00;15;34;06 - 00;16;10;09
Brandon
Financial advisors on average, when polled, would tell you that 7% nets probably a more reasonable number. Now, 12.6% net of inflation means that investing in the market needs to produce something closer, like 15 to 16% in nominal terms, and then you would deduct inflation from there. That's an awfully lofty target to set, and it's causing a lot of retail investors to make some wildly crazy assumptions about expectations when it comes to either their investment performance on their own or what they should expect from their financial advisor.

00;16;10;14 - 00;16;33;14
Brandon
If he or she is any good at what they're doing now, what's driving this very, very high target rate of return? One of the big, big, big contributions to it is what we would call recency bias. So at least in the United States, the S&P 500 has performed some very, very fantastic returns over the past couple of years.

00;16;33;14 - 00;17;03;21
Brandon
And they've been back to back. This has a tendency to cause people to assume that this is kind of the new normal. And I'm not saying that they're making the conscious decision that this is the new normal, but it kind of anchors retail investors around this idea that anything less than this is disappointing, and it tends to push up their expectations incrementally, and it's what leaves them with these highly inflated expectations in terms of what they're going to accomplish when they are invested in the market.

00;17;03;23 - 00;17;34;28
Brandon
Now, people have a tendency towards what is sometimes called illusory superiority, which tends to make people assess their strengths or their attributes as above average in all situations. And this leads them down the path of being a little too confident in their abilities to accomplish certain tasks. And this gets accentuated when making money by investing in the market gets a little too easy.

00;17;34;28 - 00;18;03;27
Brandon
So when we have multiple years of back to back double digit returns on something like the broad US stock market, we kind of feed into this Lake Wobegon effect aspect of human nature that tends to, put it into hyperdrive when it comes to expectations and just how easy they think it's going to be to go out and achieve some astronomical rate of return.

00;18;03;29 - 00;18;39;27
Brandon
And sadly, most retail investors lack the depth of knowledge and sophistication to understand just what goes into accomplishing these lofty rate of return expectations that they've set for themselves. And they especially ignore the fact that diversification is going to march in the opposite direction. Because if the broad US stock market, for example, is doing 20%. And now for that, and therefore they have set expectations of 12.6% net rate of return, but they want to add in some diversification, less risky investments in their portfolio.

00;18;40;01 - 00;19;19;00
Brandon
They don't tend to think in broad sense of overall portfolio return and kind of lose sight of the fact that adding that diversification is going to draw them back from the lofty expected rate of return they're already targeting. And interestingly, in the face of all of this is the fact that when surveyed, 80% of retail investors identify themselves as either moderate or conservative investors, meaning they would not and should not have the investment profile that would have any hope of accomplishing this.

00;19;19;00 - 00;19;50;24
Brandon
12.6% net rate of return, because they simply don't have the risk profile tolerance to invest in the things that would have any chance of accomplishing such a high rate of return, and there's one more thing feeding into this problem of analysis and inaccurate expectations that are being said, and also inaccurate analysis that's being done to likely overstate where people are going to arrive if they invest in certain things over a multi-decade period.

00;19;51;01 - 00;20;24;14
Brandon
And that is something we commonly call survivorship bias. To explain this with a bit of example, let's talk about war in bomber aircraft. So back in World War two, there was an effort to reinforce the armor on bomber planes to try and get more of them to fly their mission and return home. So certain military brass looked at the returning bomber planes and where they took damage, and had a plan to reinforce them in those areas so that they came back less damaged.

00;20;24;17 - 00;20;50;00
Brandon
But contributions to the strategy actually made by statisticians and academia corrected this thinking and likely saved a number of lives. What they pointed out was the bombers that returned home with damage in certain areas were not ones that we should look at and try and reinforce those damaged areas to increase the probability of getting more flights to fly their missions and come home.

00;20;50;03 - 00;21;31;29
Brandon
What we need to do is look at where they weren't damaged and we need to reinforce those areas. The reason being that it's obvious the aircraft that returned home had damage in non-critical areas when it came to flying the planes. It's the ones that took damage in those other areas that likely crashed because they were critically damaged. So if we reinforce those those areas on these returning planes that seem to be unharmed, we will likely better prepare these aircraft for damage in those areas, which will protect them better and make them more likely to fly their mission and come home.

00;21;32;02 - 00;22;14;10
Brandon
As humans, we have a very large susceptibility to survivorship bias. We like to celebrate victory. We don't really like to think about defeat all that often. But the sad truth is failure is a much better teacher than success. Despite our high tendency to overlook it. The center for Research and Security Prizes has a database of 64,000 open ended funds that they track for pricing movement, which means they can analyze what the rate of return of those funds is over long periods of time.

00;22;14;12 - 00;22;52;06
Brandon
There's just one problem. Currently, of the 64,000 funds in that database, only 33,000 are active currently, which means there are 31,000 funds that used to exist and now no longer exist. And when researchers attempted to reconstruct investment portfolios and gain some insight on what real rate of return would be for individuals who invested in multiple funds, including the ones that are no longer active and have ceased to exist, therefore causing losses.

00;22;52;09 - 00;23;18;29
Brandon
What we discover is that rate of return adjustments need to go down about 2% annually to capture the impact of having invested in those now defunct funds and having lost all of the investment. Now the S&P 500 index does this very thing. It's a dynamic index. So it will it'll only track the top 500 companies in the United States.

00;23;19;06 - 00;23;56;19
Brandon
So when a company goes bankrupt or falls significantly in value, it's simply deleted from the index and replaced by whomever was in 501st position. And so when we look at annualized returns of the S&P 500, it's not accurately capturing the losses that would have taken place had somebody been invested in those failed or failing companies. Now, it is true that investing in index funds or index ETFs will blunt some of the negative consequences of this, since those funds tend to absorb those losses, for the individual investors to some degree.

00;23;56;19 - 00;24;30;28
Brandon
Just by scale of the the investment, management themselves. And it's also one of the reasons why there tends to be a tracking error, not a big one, but but a tracking error nonetheless between index funds and the actual S&P 500. It's just important to understand that sometimes when we look at historical investment performance among various funds, we sometimes overlook the impact failure has had on investors because we just ignore the results of the funds that that went away or the companies that went away.

00;24;31;00 - 00;24;59;11
Brandon
We've also created a bit of a monster on social media when it comes to expectations for investments, because we see, kind of one off stories of individuals who achieve monstrous results. Reddit has been a breeding ground for this stuff, especially in the Wall Street Bat subreddit, where we see stories of individuals taking a few thousand dollars and turning it into hundreds of thousands or millions of dollars from that initial investment.

00;24;59;11 - 00;25;28;16
Brandon
It looks really great. And and some of us think, well, we should be able to do that too. But what we don't always look at are the thousands of individuals who attempted to do the exact same thing and lost everything in the pursuit of it. And yes, I realize lost porn is part of the, the Reddit investments, community, but it doesn't get near as much attention as the colossal victories that a very few limited number of people accomplish that make them very, very wealthy in a very short period of time.

00;25;28;23 - 00;25;53;26
Brandon
And Lowell's and a great number of people into thinking they can do this, too. And this should be the expectation they have when it comes to investing in the market or investing in certain parts of the market. So what do we do to get around these problems? Well, first and foremost, we do have to understand what the rate of return calculation or analysis is on the investment that we're looking at.

00;25;53;28 - 00;26;18;18
Brandon
The majority of the time it will be compound annual growth rate. So if you intend to make a systematic investment, do not use that percentage to project future values because it is an incorrect way to do the analysis. Be aware that investing can be scary and selling when the market goes down is oftentimes a good way to lock in pretty significant losses and potentially miss out on rebounds.

00;26;18;20 - 00;26;44;05
Brandon
And you should probably accept the fact that your rate of return is not going to track the stated rate of return of whatever investment that you've, you've analyzed or are looking at. And if you can make that investment and receive a rate of return that is several percentage points less and still be happy, that's fine. That's that's an investment you should make and be happy with it.

00;26;44;07 - 00;27;16;12
Brandon
But sometimes just getting average results like the index performance of the S&P 500, so long as that works for you, you should be very careful about trying to pursue some number significantly higher than that. And there is no substitution for a healthy amount of saving. So if the amount of money that you're saving and the rate of return you're likely to achieve is not going to get you to where you need to be, the answer is never look for more rate of return.

00;27;16;15 - 00;27;43;10
Brandon
In addition to all of this, I'll note that income focused investing, when done correctly, is rarely concerned all that much with rate of return in the traditional sense that it gets talked about from an accumulation focused investment strategy. Because income focused investment is much more about having or building the income that is necessary to pay for the things that you need to pay for.

00;27;43;12 - 00;28;20;26
Brandon
So when somebody gets to retirement, if they invest their assets primarily in income focused vehicles and they don't achieve anything close to, let's say, the S&P 500 standard rate of return for the past five years, they don't generally care, so long as they have the income to pay for the things that are expenses to them. And in fact, it's quite imprudent to try and increase rate of return in those situations, because in general, that will expose you to additional risk that simply isn't worth taking on.

00;28;20;29 - 00;28;43;08
Brandon
Because if you have the income producing capacity to pay your bills, why on earth would you try and risk what you have for the pursuit of something more, which you do not need? I would argue far, far too many people are focused on the wrong thing. What was my rate of return relative to the benchmark, relative to what my brother in law got on his own gain?

00;28;43;14 - 00;29;03;02
Brandon
None of that matters if you are accomplishing your goals. And when a financial advisor tells you that if he were managing your money, he would get you another point or two in overall rate of return. What you should really ask him is, well, fine, but what is your strategy? To turn my money into cash that I can spend when I'm in retirement?

00;29;03;02 - 00;29;27;16
Brandon
Because that's the reason I'm saving it in the first place. But when I tell people to stop focusing so much on rate of return, it does raise a warranted question. And that is what happens if I save too much. Like if I save money, I'm going to be deferring or possibly forgoing certain other things that I could spend my money on now that I would really like to do.

00;29;27;19 - 00;29;47;10
Brandon
So the one thing I don't really covet is a situation where I have forgone all these things, and it turns out I really could have done them because I spent way too much time saving too much money. And I know for a lot of people out there, that's going to sound like a crazy possibility. But it does happen.

00;29;47;10 - 00;30;20;12
Brandon
It does happen. Here's the thing. If you are using reasonable rate of return expectations or you're just income more focused investing and building a passive investment income, you will be able to tell if you have a solid plan where you are as time unfolds. So if your plan is accumulation focused and you assume a rate of return that is, less than a 12.6% net rate of return, maybe it's something more like a 6% net rate of return in five years.

00;30;20;12 - 00;30;39;21
Brandon
Then you find out that you are $100,000 more in an account balance than you plan to be, based on your initial rate of return expectations. Now you can make adjustments. Now you can reduce the amount of money that you're saving. Now you can go spend money on those other things that you were, delaying or forgoing in the meantime.

00;30;39;28 - 00;31;15;07
Brandon
Or if the income figures that you set for yourself the income goal that you set for yourself five, ten years out from now is exceeding what the goal was. Well, you have some breathing room and again, you can spend less money on saving and spend more money on things that you want to go out and do. But if you're simply chasing rate of return all the time, you'll have a hard time figuring out whether or not you are where you need to be and you will constantly be in pursuit of something that is very, very hard to ultimately catch because nobody knows where they're going.

00;31;15;09 - 00;31;33;00
Brandon
If all they're doing is measuring how fast they're trying to get there, and it looks like the clock on the wall is telling me, I've talked enough for today, so we'll leave it there for now. We'll be back next week. In the meantime, you can check out the Yield Terezin YouTube channel and more at Yield Trees. Incom I am Brandon Roberts.

00;31;33;00 - 00;31;40;07
Brandon
Thanks so much for joining me. And until we meet again, remember real wealth doesn't just add up. It writes, checks.