Thinking about the Monkey Portfolio

In the old days of high school we used to have multiple choice scantron tests and we used to call the monkey score the score you would get if you just randomly started choosing answers. We used to have 5 possible choices on these tests so the monkey score would be 20%.

I was having a conversation with a friend recently about financial planning and the guy is a financial planner actually. During the discussion my friend proclaimed to me that he could structure a portfolio for clients with different risk characteristics with averaged annual returns ranging between 6%~12% and that he would recommend a 12% portfolio for young people for fast growth. His reasoning behind that was that you could take any 10 year window of the stock market and find that the market compounds at an average of 10%. Since he worked at a financial institution, they had better tools to get better returns which warranted that they could get that 12%. I decided to take his statements to task to really see if this was the case... unfortunately it wasn't.

To be generous, I decided to take a nearly 30 year span of the stock market starting in June 1981 until Feb 2011 (chosen at random) to calculate compounding rate. As of June 6 1981 the Dow Jones index was at 976.88 compared to Feb 1 2011 value of 12130.45, which is a 12.4x increase. Calulating for the compounding interest rate, all I would have to do it take the root of this between the time span to find that the compounding rate to be approximately 8.86% over a 30 year period. The result is striking to me that a 10% compounding rate is optimistic at best and 12% is a bit out there.

The Dow Jones Index since June 1981 to Feb 2011

So next, I decided to do take this a step further and assumed that I invested into the market at a constant rate of $1000/month for whatever the price the Dow Jones Index was going for until the beginning of Feb 2011, what would the annual compounding rate be after ~ 30 years? The result is illustrated in the graph below:

 

Compounding rate calculated while making constant contributions

Sure there is a lot of movement in the compounding rate in the initial few months but as time slogs along the compounding rate begins to stabilize at 6% but drops down to 4.7% after the recent economic crash. From the results we are nowhere close to achieving the 10% compounding rate that was initially proposed. Just as a note, the graph bottom axis is in months but has the same time span as the above Dow Jones plot, I was just too lazy to change the axis.

The gains however are still significant even at a lower compounding rate though, assuming a $1000 contribution into the fun over 356 months, the total contribution turns out to be $357k (assuming +$1000 at month 0) with a portfolio value of  $1.38 million after nearly 30 years of constant investing. Sure the market might have had compound growth in the upper 8% range, but the dollar cost averaged purchases of stocks over the past 30 years tells a different story. The guy was obviously making a pitch at me and setting reference points is a common sales tactic, but the reality of the matter is that a 10% continual compounding rate is optimistic. When it comes to financial advice and products, keep your wits about you.