the double digit myth

Quoting directly from an annual report is not something I’ve done before on Brip Blap, but I thought this little nugget from Berkshire Hathaway’s CEO Warren Buffett was worth sharing. Friday’s annual report to shareholders is available on Berkshire Hathaway’s website.

From Fortune:

[Buffet] writes that the Dow Jones Industrial Average surged from 66 to 11,497 during the 20th century. That is a huge rise – yet it averages out to just 5.3% compounded annually, Buffett writes. What’s more, were the DJIA to repeat that 5.3% average annual gain throughout the 21st century, its value on Dec. 31, 2099, would approach 2 million.”It’s amusing that commentators regularly hyperventilate at the prospect of the Dow crossing an even number of thousands,” he writes. “If they keep reacting that way, a 5.3% annual gain for the century will mean they experience at least 1,986 seizures during the next 92 years. While anything is possible, does anyone really believe this is the most likely outcome?”

If that scenario isn’t outlandish enough, Buffett goes on to note that were stocks to return 10% annually throughout this century, the Dow would hit 24 million by year 2100. “If your adviser talks to you about double-digit returns from equities,” he writes, “explain this math to him – not that it will faze him. … Beware the glib helper who fills your head with fantasies while he fills his pockets with fees.”

I’ve written about this before. I am constantly amazed at the fervor people bring to the concept of long-term guaranteed double digit returns in the stock market if you invest in index funds. I am even more amazed that people hope for the US market to continue at these rates of growth, since I think the explosive days of US growth are behind us, as a country. The simple truth is that unless you are a very good investor (and they exist – I don’t deny that) you probably can’t beat the market. 75% of mutual fund managers can’t, either. What is most likely is that you can count on a before-tax return of less than 6% per year – before taxes.

I know the DJIA is probably not the best single measure of returns, and I know different time spans would result in different return rates, and I know there are variables such as tax treatment, dividends, etc. that might affect this calculation. But the best investor in America (if not the world) thinks that counting on the general return of the market to exceed 5.3% is foolish, and I have to pay attention to his opinion since he seems to have a good understanding of investing, to say the least.

I use the “index fund method” of investing, buying broad-based index funds that mirror the performance of the market. If I look back in 20 years and see 5.3% returns per year I will kick myself for not buying CDs instead and avoiding the volatility which is giving me nightmares today. I sometimes wonder if I do need to put more effort into actively picking stocks, instead of hoping for the lift and swell of a troubled, debt-ridden country’s over-regulated stock market to carry me to retirement. It’s enough to make you sleepless at night in times like these.