10% Return is Better than 8% -- But is 8% all that Bad?
See how settling for less plays out over your investing lifetime
Ric Edelman: It's Monday, April 24th. A couple of weeks ago, I said that the biggest scam in investing today is ESG (environmental, social, governance), mutual funds and ETFs that invest with a filter so that they only invest in companies that pay attention to ESG values. I said that a lot of people have invested in ESG, and so that's pretty cool, right? You can align your investments with your values. But I also said that that's nothing but a sales pitch. Of the 120 funds that currently have a Triple-A rating for adhering to ESG, the company that awards those ratings is about to announce that they've been wrong. And of those 120 funds that they currently gave a Triple-A (AAA) rating to, only 54 of them actually deserve to have that Triple-A rating.
So if you've bought any of the other 1066 ESG funds, you've been bamboozled. Not only that, I said, but if you look at the past one-, three-, five- and 10-year time periods, ESG funds have underperformed the overall market as measured by the S&P 500. So I asked, are you really willing to earn less just so you can feel good?
Well, one listener said to me, “Hey, Ric, what's the big deal? So what if my ESG fund underperforms a little?” He said he looked at his ESG fund and he found out that I was right. He earned less than the S&P 500. He said over the past several years, his ESG fund has earned 2% less than the S&P 500. And he said, “Ric, I'm willing to live with that.”
Well, I hope you change your mind. And here's the message of today. It's not really about ESG. It's not really about investment scams and frauds. What it's really about is your need to understand the power of compounding. This failure to understand is one of the biggest reasons for investors failing to achieve financial success.
This guy said to me, “Hey, you know what? I'm earning 2% less by investing focused on my values.” And he thinks that earning 2% less a year isn't a big deal. Well, let me just demonstrate for you how big a deal it is. We're going to compare two different investments in a hypothetical example. One of them earns 10% a year. That's the average annual return of the stock market since 1926. So 10% a year versus 8%. So that's what this guy is telling us, that his ESG fund has earned only 2% less.
So here's the first point. 2% less. No, it's two percentage points less. Earning eight instead of 10. That's a 20% reduction, not 2%. It's really important that we understand the difference between a percent and a percentage point. I mean, think about it. Let's talk about the difference between 1% and 2%. What's the difference? 50%. Right. What's the difference?
Well, in order to go from 1% to 2%, you'd have to double. That's a 100% increase. Or if you have the 2% and you're cutting it down to one, that's a 50% reduction. It's only one percentage point, but it's either 50% reduction or 100% gain.
You've got to make sure you understand the difference between percentages and percentage points. Now, with that in mind, look at what happens if you earn 10% over 40 years as opposed to 8% over 40 years. This guy thinks, oh, it's only 2% a year difference. What's the big deal? Well, let me tell you what a big deal it is. I'm just going to use a simple $1,000 investment. You invest $1,000 today, you do it and you hold that investment for 40 years. So you start at age 30 and you hold on to it until age 70 at 10% a year, $1,000 will grow to $45,000, but at 8% it grows to less than $22,000. In other words, that little extra difference, 10% instead of 8% more than doubles the end result.
Consider that you're not investing a single lump sum today because most of us don't. Most of us invest slowly over time. As we get more and more paychecks, we invest more and more of our money. Think about your 401(k) at work, right? You get a paycheck, some of the money goes into your retirement account. Let's invest $100 a month over a 40-year period. If you earn 10% a year on all of that money over 40 years, $100 a month, you'll end up with $632,000. But if you only earn 8%, you won't have $632,000. You'll only have $349,000. Again, a little bit more than half the difference between 8% and 10%. This is why it is so vital that you understand the importance of earning higher rates of return.
When people tell me that they're satisfied with their money in their bank account, earning 3% or 4% a year when they could be investing in the stock market at 8% or 10% a year, you see the incredible difference in end result. Don't be dismissive of the extra couple of points that you might be able to earn in alternative investments from what you're doing right now. If you truly want to achieve your financial goals, you've got to earn the rates of return that are provided by the financial marketplace. And don't just be a shrug, you're saying, “Yeah, what's the difference? It's only a couple of points.”
And don't take this cavalier attitude of, ‘Oh, this is good enough’. It really isn't. The difference between 8% and 10% is doubling how much money you have in retirement. Imagine the difference between 4% and 10%. Make sure you're focusing on the rate of return. Make sure you're not denying yourself and your family future financial security.
Hey, tomorrow at 2 p.m. Eastern, I've got a one-hour webinar and you're invited. It's free. I'm going to be doing it with Bitwise CIO Matt Hougan. How Crypto Is Really Going To Change the World: Real World Use Cases. It's a virtual event online. It's aimed at financial advisors who receive one CE credit. You can attend as well. Register right now at DACFP.com. The link is in the show notes and hope to see you there tomorrow at 2 p.m.