Wednesday, September 7, 2011

Average Rate of Return

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%. If we account for three years of inflation our $100 now has the buying power of about $83. Obviously this is as pretty extreme example, and my first thought was that this would likely never happen to a market index. Upon further research I realized that not only could it happen, but it has happened, and could be happening right now!
            As you see below the Dow Jones Industrial Average between 1963 and 1983 peaked five times at or around the 1000 level, and then dropped back down to or below the 775 level five times. This is a real life example of what we just illustrated. If someone put $100 into the market in 1964 they would still only have $100 18 years later in 1982. This is known as a sideways market. This particular sideways market lasted for almost 20 years.

            Our current situation is not too far off from the same thing. When you look at a chart from 1997 to 2009 you can see that the market has gone up and back down to a starting point twice just like it had in 1971. When the S&P 500 bottomed out at 666 people began calling this situation the “Lost Decade” because if you invested $100 ten years ago you would only have $100. It’s like you didn’t do anything. As we look at the situation of 1971 they still had 10 more years of a sideways market? Does this mean that we have another 10 years of a sideways market today?

            This concept demonstrates how averages can be manipulated to say what the manipulator wants, and the difference between average and actual. 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 at the end of that year you would have $62.72. If I want to gamble I will go to Vegas, but when it comes to my retirement I don't mess around.


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