I work with a number of prospective clients and existing clients who have heard or read that the market returns 10% or more on average each year. Usually the implication is that they can expect, over a long time, a 10% return. Fortunately some ask, with some doubt, "Is a 10% return really reasonable?" It is not.
Whilethe average growth or return in the market (e.g., the S&P 500) is about10%*, investors over time do not see that. Why? First, it is pure mathematics. (Other factorsare noted at the end.)
When calculating the average (or "mean") market return the math involved is called an "arithmetic mean." Most of us are familiar with that calculation - add up each of the numbers and divide the sum by the quantity of numbers included. Pretty simple.
But an investor will realize an annualized return equal to the "geometric mean" of the individual annual returns. (This of course assumes that the investor stays invested. The topic here is really math, not investments. It just applies to investments.) The calculation of the geometric mean is much more complicated involving multiplication and the nth root of the resutls.
Example
Each of the following columns contain a series of "returns" that have an arithmetic mean of 10%. It is illustrated with a single investment of $100. After a couple ofyears, compare the results.
| Scenario 1* | | | Scenario 2* | | | Scenario 3* | |||
|---|---|---|---|---|---|---|---|
| $100 | | | $100 | | | $100 | |||
| +10% | $10 | | | +20% | $20 | | | +30% | $30 |
| $110 | | | $120 | | | $130 | |||
| +10% | $11 | | | 0% | $0 | | | -10% | -$13 |
| $121 | | | $120 | | | $117 | |||
| 10% Annualized Return | | | 9.5% Annualized Return | | | 8.2% Annualized Return | |||
The "average" return in each column is 10%, but the "annualized" or "realized" return is not. As you can see, volatility really hurts the overall long-term performance. But that volatility is very real, and a reality for investors. (Sample values shown are not representative of any market or investments, but simply illustrate the mathematical results of a geometric mean.) Mathematically, the geometric mean canneverbe larger than the arithmetic mean.
So what might one realistically expect their investments to return? That is dependent upon the mix of their portfolio and, of course, how the market performs over the time involved.
Two more issues on investment returns (as promised above):
- Stated returns on a broad range of stocks such as the S&P 500 generally do not include dividends, which can be a significant source of income. Including re-invested dividends can result in a calculate return significantly higher.
- Stated returns on an index such as the S&P 500 generally do not take into consideration inflation. Adjusting the results for inflation will result in a calculated return significantly lower.
Notes:
*See articles such as "What is the average annual return for the S&P 500?" byJ.B. Maverick which is posted on Investopedia (http://www.investopedia.com/ask/answers/042415/what-average-annual-return-sp-500.asp).
Standard & Poor's is a corporation that rates stocks and corporate and municipal bonds according to risk profiles. The S&P 500 is an index of 500 major, large-cap U.S. corporations. You cannot invest directly in an index.
*The rates of return shown above are purely hypothetical and do not represent the performance of any individual investment or portfolio of investments. They are for illustrative purposes only and should not be used to predict future product performance. Specific rates of return, especially for extended time periods, will vary over time. There is also a higher degree of risk associated with investments that offer the potential for higher rates of return. You should consult with your representative before making any investment decision.
