Saturday, August 2, 2008

What "average" returns really look like

Yesterday we assumed a 10% return on our hypothetical investments.  The rate of return has a huge effect on the outcome of both these hypothetical scenarios and your real life investments.  So how predict the performance of your investments?

In short, you can't.  It is impossible to predict the return on investments in stocks, bonds, and mutual funds.  However, if you have a diversified portfolio we can use historical averages as our guide and estimate reasonably well.

According to the Motley Fool, from 1926 - 1998:
  • U.S. Treasury Bills returned an average of 3.7%
  • U.S. Corporate bonds returned an average of 5.7%
  • The S&P 500, which is a good measure of the stock market, returned an average of 11.2%
You can use these numbers to form a solid estimate of how your investments will perform.

Those averages certainly make stocks look very appealing - and they are.  However, remember that higher returns are always associated with higher risk, and in the financial world risk = volatility.  Those are the averages, to see what those numbers looked like year-by year look at the following graph.

In this graph you can see that even though the S&P 500 averaged around 11% over this time period, from year to year the index was anywhere from down 40% to up 50%.  Returning 11% in any given year was a very rarer occurrence.

What this graph says to me is the volatility in the stock markets is not new or unusual.  Volitility is a part of how the stock market works and in the long run will not prevent you from meeting your financial goals.

Tomorrow, I will share an investing strategy that helps use these peaks and valleys to your advantage.

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