Beware Vanguard 500 Faulty Logic & False Performance Measures for Investments
Update 8/4/07: This article originally was based on Google Finance Beta's "10y" graph on 8/3/07 but the "10 year" graph did not cover 10 years (thanks, Google) so I re-adjusted the article for 8 years.
When Claims of +160% End at -20%
The Vanguard 500 S&P 500 index fund, often claimed to give a 12% return on investment (ROI) rate, closed today at $132.16, an excellent lesson in real returns.
Misleading "Average Annual Returns"
First, note that average annual return rates tend to overestimate your gains.
Simple hypothetical of a $100 lump-sum buy-and-hold:
Year - Investment - Return
0 ............ $100 ......... -
1 .............. $50 ...... (50%)
2 ............ $100 ...... 100%
Average annual rate of return: (100 + (-50))/2 = 25%
You started with $100 and you ended with $100 but your $0 gain shows +25% average annual return.
Of course, you actually have 0% gain on your initial value after 2 years.
Use the Geometric Mean Instead.
What if you put your $100 in the Vanguard 500 VFNIX 8 years ago?
If you expected 12% per year, you expect to find your $100 investment to have grown to $260 after 8 years, a 160% increase over your initial value.
De Ja Vu: "Hey, this is where I started!"
However, the Vanguard 500 spent the better part of the last decade in the V-graph pattern of our simple hypothetical: The VFINX share price was about $130 about 8 years ago and closed at about $132 today, which is about 0% growth after 8 years.
Real Negative Returns
If inflation were about 3% per year, then the Vanguard 500 performed as if it had been losing your money at -3% per year.
The real value of your initial $100 is now about $80. You lost 20% of your real money over the last 8 years.
Some say, "Invest as early as possible!", but today you can buy VFINX at about the same dollar price (less in real terms) as 8 years earlier and have the same nest egg at retirement as the person who invested 8 years before you--and meanwhile your money could have been accomplishing other things for the past 8 years.
Some say, "Invest instead of paying off your mortgage!", but someone who had a windfall 8 years ago and chose to invest the lump sum in the Vanguard 500 instead of paying off a mortgage would have done even worse than the real 20% loss by adding the mortgage's real negative return to the VFINX's real negative return.
"In the long run, we are all dead." -- John Maynard Keynes
VFINX eventually will rise again and you can find other timeframes with higher returns on investment (ROI) but remember that certain investments or markets can be flat or worse for a decade. Even if Investment A beats Investment B in the long term (several decades), Investment B might beat Investment A in the short- or mid-term. You might have an immediate goal such as paying off a mortgage or other debt that can make you thousands of dollars richer than borrow-to-invest schemes when alternative investments are in--or are about to enter--the doldrums.
Always do the math for your specific circumstance and do not rely on optimistic promises.
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