Why Average Returns Are Misleading
I often write about financial planning strategies that assume a rate of return. I try my best to use reasonable assumptions but even these assumptions can be misleading.
For example, the average return was 10% for the S&P 500 (or similar index) over the past 90+ years. Investing would be a whole lot easier if we could have the assurance that the 10% would come every year. Unfortunately, it doesn’t work that way.
In fact, annual returns for the S&P 500 have only been “average” (between 8% and 12%) 5 times since 1926! It is this variability and uncertainty in the short term that has led to great long-term returns in the first place. Investors demand a higher rate of return for higher risk. But this risk can create great planning challenges for investors looking for certainty that their money will never run out!
However, there is hope for your financial plan. The longer the time horizon, the narrower the range of possible outcomes. Here is a chart that shows stocks, bonds, and T-bill returns for different lengths of time1.
Over 1 year, returns have varied from –38% to +66%
Over 10 years, returns have varied from –4% to +16%
Over 30 years, returns have varied from +2.6% to +10.6%
The returns certainly become more predictable but it can be frightening to see an entire 30-year period where returns were a paltry 2%! That could very well be someone’s entire retirement. It’s easy to see why someone who started investing in 1927 right before the Great Depression might explain to their child that the stock market is rigged only to have that child scared out of the market just in time to miss out on some of the best returns the US has ever seen.
While this might make some feel like investing is gambling, it certainly has proved to be anything but over the long run. To combat the uncertainty of returns, I suggest developing a “base case” financial plan and then adjusting the plan to accommodate for some margin of error in case you are on the lower end of the “average.”
Thank you for reading,
Alex
This blog post is not advice. Please read disclaimers.
1 - Siegel, Jeremy J. Stocks for the Long Run: The Definitive Guide to Financial Market Returns & Long-Term Investment Strategies. McGraw-Hill Education, 2014.