Friday, July 20, 2007

Beware Vanguard 500 Faulty Logic & False Performance Measures for Investments

The Vanguard 500 S&P500 index fund is popular in the buck-o-sphere (PF blogosphere) and bloggers often cite its historical annual rate of return of 12% since inception in 1976. However, besides the usual caveat that past performance is no guarantee of future performance, too many people ignore another vital factor. The Vanguard 500's real performance is not nearly as stellar as many believe.

Confusing Nominal V. Real (Inflation-Adjusted) Returns
& Confusing Today's Inflation Rates V. Past Rates

Dough Roller recently remembered earning more than 10% on Certificate of Deposit (CD) during the high inflation of the 1970s/early-1980s. Indeed, consumer prices rose 13.3% in 1979.

Forgetting to count inflation--and forgetting that past inflation was quadruple current official rates--will cause you to overestimate historical investment performance. The Vanguard 500 averaged 12% annually since mid-1976 but double-digit inflation makes a 12% return pitiful. A fund with 12% growth during 12% inflation is no better than a fund with 3% growth during 3% inflation.

Before you "beat the market," at least beat inflation.

"Beating the market" compares your fund relative to other funds, which could mean that your fund lost a lot while other funds lost even more. This is small consolation, since schadenfreude will not pay your bills.

You need real, after-tax gains to buy food in retirement.

Use real rates of return (not nominal rates of return) to get a more accurate measure of historical performance. This lesson applies to any investment.

See also:
Vanguard 500 VFINX Loses 20% of Your Money from 8 Years Ago
Destroy Your Retirement Nestegg with Happy Thoughts
Never Prepay Mortgage? Housing Myths Part 1


Brip Blap said...

I couldn't agree more. There's definitely an effort by the mutual fund companies to push 'gross' gains rather than 'net' gains. If we were all being told the returns net of inflation, fees and taxes most of us would think twice about putting our already-taxed-once wage income into the market.

J at IHB and HFF said...

Brip Blap,

Hello. Yes, a fund might be a good choice but we need to see through the marketing hype.

Thank you for the comment and please visit again.