Monday, February 15, 2010

Rate of Return - Bench Mark

First I would like to thank everyone that comments. Second I would like to encourage people that are new to this blog to read previous post in order to catch up. For example, this post is a direct lead off of the post "Needs Based Planning." If you read that post this one will make a little more sense.

When it comes to needs based planning, one of the variables most likely to be off is rate of return. Rate of return (R.O.R.) is the gain or loss from an investment over a period of time expressed as a percentage of the original amount invested. So, if I invest $100 and in a few months I sell my investment for a total of $125, then my gain or loss (return on investment) is $25, and if expressed as a rate of return is 25% ($25/$100). Investors use rate of return to gage their investment and know how well it is doing. The ultimate bench mark, and what most investors try and beet is the Standard and Poor’s 500 (S&P 500). The S&P 500 is an index comprised from the stocks of 500 companies selected as a representation of their specific industries. The goal of the S&P 500 is to reflect how good or bad the U.S. economy is doing.

It is said that the S&P 500 index averages a 10% annual rate of return. That means that year to year the S&P’s average annual return is 10%. Even though most people accept the average rate of return as 10%, between 1971 and 2009 it is actually 10.59%. This means that when investors are trying to beat or match the S&P 500 as a bench mark they usually expect about a 10% return. However, average and actual returns are two different things, and averages can be very tricky. I’ll give you an example of what I mean. Let’s say that we invest $100 in the stock market. In Year 1 we receive a return of 100%. So after Year 1 we have $200. In Year 2 we lose 50% (return of -50%). We now have $100 again. Then in Year 3 we gain 100% again. In Year 4 we lose 50%. In Year 5 we gain 100%, and in Year 6 we again lose 50%. After 6 years we now have $100. This is demonstrated by the chart below.

So, our average rate of return is 25%, but if we started with $100 and ended with $100, then our actual rate of return is 0%. Obviously this is as pretty extreme example, and I seriously doubt this would ever happen with any market index. However, it demonstrates the difference between the average and actual rate of return. If you would like to know the actual annualized (year over year) rate of return for the S&P 500 between 1871 and 2009 it is 8.89%. However, that comes with an average standard deviation of 18.94%. For those of you who are not statisticians, this means that any given year can have a return that varies at least18.94% in either direction. For example in 2008 the return of the S&P 500 was -37.22%. In 2009 it was 27.11%.  What does this mean to the average investor? It means that your actual return depends on your timing. If you put $100 into the market at the beginning of 2008 you would now have $79.80.


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