Excess Returns and Law of Diminishing Returns

It’s human to sometimes yearn for more than the ordinary.  In the case of investing, we yearn for “excess returns”.  Simply put, excess returns are above and beyond the returns ordinarily available from investing in a broad-market index fund.  Market returns are often called “beta”, while excess returns are called “alpha”, which implies excess returns are inherently superior to mundane market returns.

I decided a long time ago that seeking alpha was not a particularly mindful investing strategy.  Among other things, it’s nearly impossible, and in most cases, it’s completely unnecessary. In the pages of Mindfully Investing I’ve supported this conclusion with stacks of data and careful consideration of the opinions of many smart and experienced investors.

Nonetheless, I see stuff everyday calling these obvious facts into question.  Many prefer the self-deception that they probably have the skill to find and tame the elusive beast of excess returns.  But like the Greek myth of Actaeon, the more ardently they hunt, the more they risk instead having their portfolios ripped apart by their own hounds of pursuit.

I’ve struggled to find better ways to illustrate the futility of hunting for excess returns.  So, here’s a new way to think about it that you’ve probably never seen before.

The Most Important Investing Graph That You’ve Never Seen

Try googling, “the most important graph in investing”.  You’ll get all sorts of interesting candidates, some of which look something like this example I generated using Portfolio Visualizer.

The graph shows how U.S. small cap stocks (red line) outperformed U.S. large cap stocks (blue line) by about 1.65% annualized since 1972, generating nearly a million more dollars from an initial $10,000 investment.  It’s easy to find many types of graphs like this supporting one pitch or another for how to obtain excess returns.  They’re all based on the question: how much money will you generate in a given time span?

But what if we turn that question on its head, and look at: how much time will you need to generate a given amount of money?  Upside-down thinking is the favorite tool of expert investor Charlie Munger, who likes to say “Invert, always invert.

Inverting this question results in what I think is the most important, but simple graph in investing.

For each additional percent you try to obtain above the market return, the less impact you have on the time it takes to meet an investing goal.  In the case of this graph, the goal is doubling your money.  Situations where greater efforts lead to ever lessening benefits (if all other variables remain the same) is often called the law of diminishing returns.  Here the “returns”, or benefits, are in the form of time saved on the vertical axis, which shouldn’t be confused with the investment return rates on the horizontal axis.

Let’s look at a specific example.  In this version of the same graph, I’ve added notes showing the historical and expected-future returns for bonds and stocks.

The expected future market return for stocks is about 5%.  At that rate of return it will take about 14 years to double your money from a one-time initial investment.  What if you worked really hard to beat that market return by one percent?  Then you double your money in about 12 years.  So, for all that hard work, you saved about 2 years out of more than a decade.

Because no one can predict the future, the stock market could produce returns more like the historical return rate of 9%, in which case you’d double your money in 8 years.  If you tried hard for a 10% return instead, you’d have saved yourself less than 1 year!  And this analysis assumes that your concerted efforts come with no added investing costs, which is usually not the case.

To illustrate it another way, this graph shows the amount of time you’d save by obtaining each additional percent of return.