Since 1926, the average annual return on large-cap stocks has been 9.62%. This means you can bank on an average return for stocks of about 10% per year over the long term, right? Well, yes and no.
Take a look at the following chart:
What this chart shows is that while the average annual return is about 10% (the red line), returns from year-to-year are quite variable. In fact, only five years out of the last 83 had a return that was plus or minus two percentage points from the average return (the blue lines indicate this range). So, while it’s great to think you can achieve about 10% per year invested in stocks, the reality is that in any given year, your return will vary significantly from the average. You can be up 30% one year and down 40% another. That’s pretty different than up 10%.
So what does this mean for a stock investor? Three things immediately come to mind.
The first lesson is to stay invested. In Nassim Nicholas Taleb’s book The Black Swan: The Impact of the Highly Improbable, he recounts that over the past 30 years, the S&P 500 without reinvested dividends has returned about 9.5% per year on average. By removing the 50 worst days in the market over this 30 year period, your average annual return would have jumped to 18.2%. On the other hand, if you missed the 50 best days in the market over the last 30 years, your average annual return would have plummeted to less than 1%. Bear in mind that fifty days out of 30 years is less than 0.7% of the sample. This clearly shows that being out of the market, even for a very small percentage of the time can have a rather large impact on your portfolio’s performance. So, unless you can accurately and consistently predict when to get into or out of the stock market (also known as market timing), the best philosophy is to stay invested.
The second lesson is, if possible, to start investing early. For younger folks, it cannot be emphasized enough that to have a successful investment plan for your retirement, you must begin saving early and often. By starting early, you can smooth out the bumps created by year-to-year market swings. The more years you stay invested, the closer you can get to that average annual return of about 10%. Albert Einstein had it right when he said, “The most powerful force in the universe is compound interest.” Obviously, the longer your portfolio benefits from compounded earnings, the better.
The third lesson to be learned from the chart is to have a long time horizon. For those closer to retirement age, it is important to understand that the year-to-year variability of stock investments requires you to have a longer-term time horizon. You cannot expect that for every year after you retire, the stock market will go up exactly 9.62%. Again, by having a longer time-horizon, the impact on your portfolio of year-to-year variations in stock market returns can be reduced.