Introduction
10% per year is the long-term, frictionless expected return of owning a diversified stock portfolio. It's what investors have gotten historically, and it's what we expect in the future.
If you've managed an investment account (large or small), you know firsthand that the human brain is a friction. It confuses activity with productivity, it weaves false narratives to support ego, it tells us that we are sane and everyone else is crazy.
History, and economic rationale, tell us that the 10% per year is ours for the taking...unfortunately, investing is spreadsheet-easy, but human-hard.
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My wife and I started watching The Wheel of Time on Amazon Prime last week. The main characters have the ability to conjure magic to escape imminent danger and death, and instead kill their attackers with a wizardry, supernatural forcefield of lightning power.
It irks me. I can't get into the lack of accountability.
The Greek and Roman playwrights used similar devices to help characters escape danger. They had an actual, crane-like machine on stage to assist. Unsurmountable circumstances, but a little help from above, and it's all good. Divine intervention.
Deus ex machina. God from the machine.
No such luxury exists in building wealth through investing. The stock market is indifferent to your preferences, your desires, and your plight.
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What follows is perspective on capturing the 10% per year that you deserve, why humans stink at investing, considerations on large numbers and our brain's difficulty to splice the factors that drive compound returns, how your starting wealth can be just a small factor in determining your future wealth, and finally why investment success doesn't require divine intervention, just that you be less human.
Part I: Skew
Here is a reasonable outcome for a coin being flipped 100 times, easily visualized:
It's only heads or tails. Binary distribution. Easy to understand.
As data gets more complex, we need to be more intentional with how we visualize it.
For analyzing adult human heights, we may choose a bell curve.
Tall parts of the curve represent a lot of data points, and short parts represent a small number of data points.
Moving from left to right, you have humans of extremely short relative stature to humans of extremely tall relative stature. The majority of us are somewhere in the middle; the average human is 5'7".
This is a fairly normal distribution, which simply means that even after accounting for our range (Chandra Dangi on the left side, and Robert Wadlow on the right side), the sandbox of possibilities is only 2-feet to 8 1/2-feet, and no extreme outliers.
Here is Robert with his family:
Because we don't see this everyday, it looks like a wild picture. But it's not a wild dataset.
Robert, who was a peach of a guy, is only twice as tall as his younger sister Betty in front of him. That's just 2X more than the shortest person in the picture, which is just not that wild.
Wealth distribution is wild:
The average adult net worth in the U.S. is $80,000
Elon Musk's net worth is $261,000,000,000
Elon Musk is 3,250,000X richer than the average American. Robert was only 2X taller than his shortest sister. He was only 4X taller than Chandra Dangi!
The bell curve for wealth distribution would have something like this pattern, with rich folks tucked comfortably underneath the tail extending rightward:
Part II: Black Swans & Dragon-Kings
Nassim Talib famously called events that are hard-to-predict, but have extreme effects (and are rationalized by humans after-the-fact as easier to predict than they actually were)...black swan events. There's been a swelling of interest in analyzing the occurrence of rare events, there are even papers about studying the "black swans of black swans" – called dragon-kings. Didier Sornette's own words on coining the phrase:
"Dragons to stress that we deal with a completely different kind of animal, beyond the normal...
[Kings] analogy with the sometimes special position of the fortune of kings.."
The special position of the fortune of kings. We know this position: it's deep in the right skew of the bell curve. It's a wild dataset, but this wealth distribution isn't new. There were Elons before Elon.
Most of us are not interested in being mega-wealthy, but simply in being wealthy enough to afford not having to think about money very often.
Investing consistently over long periods is the ticket, but it's hard.
Part III: Spreadsheet-Easy But Human-Hard
Using data back to 1926, here is each year's return of the S&P 500, which is basically the frictionless return of a portfolio that's invested in the stocks of large, well known companies in the U.S.
The orange line is our 10% per year historical average. Don't let your brain trick you (it will try): there are no discernible patterns in the blue dots. There is nothing consistent nor predictable about stocks from year to year.
BUT the orange line looks perfectly smooth (it is). It's misleading. Nothing about getting the long-term average is easy...the entire investment journey, and the entire process of being an investor, is not something humans are wired to do well.
We are wired to be risk averse, and to flee danger. We are wired for self-preservation, thereby avoiding small risks that may have outsized, upside opportunities. Wired to see patterns when they don't exist: like animals in clouds and faces in trees. We relentlessly seek patterns.
We are wired to win games of luck and consider ourselves skillful, and lose games of luck and consider ourselves unlucky.
One of the hardest things to do as investors is manage the extreme, rare events.
A distribution of stock market returns looks a lot like the distribution of human heights:
Except for one, big thing: the distribution of stock market returns has tails on both sides. Extreme, rare events occur more frequently than we'd expect:
Effectively managing the experiences in these tails is a prerequisite to achieving the long-term average. We aren't wired to do it, which is why so many sadly don't.
You can't get scared by 2008's -37%, and miss one of the greatest wealth accretive stock markets in the decade that followed. You can't take some off the table after a good year, thinking a bad year must come next. There is no data that supports this approach.
There is just the orange line.
And someday in the future, there will be more -30%, -40% and -50% drops in the stock market. There will be more left tails. It's not a reason to avoid investing in stocks. The 10% per year long-term average exists alongside them, in spite of them, and partially because of them. There would be no expected reward without accepted risk.
That risk is not natural to us.
Spreadsheet-easy, but human-hard.
Part IV: Levers
Want more money? Here are three levers to pull on:
Invest more
Get a higher return
Wait longer
For the sake of a dramatic example on these levers, let's bring Elon back. Here are six ways to start with $10,000, and end up with slightly more than $261,000,000,000, and be richer than Elon Musk:
Starting Value | Annualized Return | Years | End Wealth |
$10,000 | 452% | 10 | $263,000,000,000 |
$10,000 | 135% | 20 | $264,000,000,000 |
$10,000 | 77% | 30 | $274,000,000,000 |
$10,000 | 54% | 40 | $278,000,000,000 |
$10,000 | 10% | 179 | $266,000,000,000 |
$10,000 | 7% | 252 | $263,000,000,000 |
None of these will happen, but none of us need Elon's wealth.
Let's isolate the bottom two, realistic returns. Consider what happens to the annualized return we need, when in pursuit of $261,000,000,000, we start with $100,000 (instead of $10,000) over the same number of years:
Starting Value | Annualized Return | Years | End Wealth |
$100,000 | 9% | 179 | $263,000,000,000 |
$100,000 | 6% | 252 | $262,000,000,000 |
Hardly anything happens! You still need 9% (instead of 10%) over 179 years, or you still need 6% (instead of 7%) over 252 years.
Starting wealth is only one of the levers we can pull on, and over longer periods it matters less and less.
Each year forward, more of your returns are driven by current returns on historical gains.
Eventually, it's not about gains on what you started with, it's about gains on your gains since you started.
For investors with long-term time horizons, it's about getting the ball rolling without ruing so much about the ball's initial size.
Now let's keep $100,000 as our starting point, let's get rid of dramatic comparisons to Elon, let's lock in our 10% return, and see ending wealth over various time frames:
Starting Value | Annualized Return | Years | Ending Wealth |
$100,000 | 10% | 5 | $161,000 |
$100,000 | 10% | 10 | $259,000 |
$100,000 | 10% | 15 | $418,000 |
$100,000 | 10% | 20 | $673,000 |
$100,000 | 10% | 25 | $1,083,000 |
$100,000 | 10% | 30 | $1,745,000 |
$100,000 | 10% | 35 | $2,810,000 |
This is frictionless. This is the type of outcome we want to engineer. And the longer you're invested, the more clarity you'll have around getting +10% (because you've mitigated the impact of future events in the left tail).
The more clarity you have around the +10%, then the more confidence you have around achieving the commas and zeros in the right column.
[Remember that these numbers are only on a $100,000 initial amount. They get much larger if you keep adding to your portfolio through time.]
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Start with a diversified, low cost approach that seeks to own a little bit of every stock in the world. That's your slice of global capitalism...it's the most prudent pursuit of the long-term 10% return.
Mentally recalibrate downturns as necessary elements of the system. It's not easy.
Be automated. Be systematic. Be emotionless. Also, not easy.
Remove the friction of being a human: don't act on opinions, don't search for patterns, ignore advice from people who search for patterns. None of this is easy.
Conclusion
This is my last post of the 2021. I'm really grateful for your readership.
Next year, I hope you're so human. Spend time meaningfully, think deeply, and love carefully. Apologize purposefully, and genuinely. Use time judiciously.
This has been a brutal couple years. Do not be an automated, systematic human to other people. Be authentic, and compassionate. Tell people you miss them. Be emotional.
But when it comes to investing – step outside your humanity, and be an effen machine.
-Rubin