Friday, October 11, 2013

Average Annual Returns Mean Less Than You Think

Ask anyone what stock market returns they should expect and they will quickly respond with something like 8% or 10%. Ask them how they arrived at that number and they will tell you it's the historic market return average, more often than not meaning the S&P 500 index.

The time period we use to calculate that average can have a significant impact on those numbers. Do we measure the real returns since 1871 provided by Robert Shiller of about 6.7% a year? Do we measure from the Great Depression (about 7.5%)? The end of World War II (about 6.5%)? How about the past 50 years (about 7.6%)?

(These are real “after inflation” returns. Nominal returns are about 3% higher.)

No matter how you measure, compound growth rates (CGR) are probably less important than you think.

Market averages tell us how a market index performed over a given time period. There are 1,332 rolling 360-month periods of S&P 500 market returns in the Robert Shiller data from 1871 through 2012. The average real return for those periods was 6.7% a year (8.9% after inflation). But as an individual with a 30-year retirement, you would have lived through only one of those periods.

It might have been one with a 6.7% real return, or it might have been the one with a whopping 11.2% annual return on the right of the chart above. Then again, it might have been the one with the 1.9% annual return on the left. The average doesn't imply as much with a one-time event like an individual retirement. If you lived several hundred lifetimes, 6.7% would be a good bet (but retirement planning would be a bear).

As I showed in recent posts on the topic of sequence of returns risk, a retiree might earn 3% annually and successfully fund thirty years of retirement. But she can also earn an average 7% and go broke in less time. The order of the market returns can be even more important than the average of those returns if you choose to spend down a stock portfolio after you retire.

Lastly, no one earns market index returns over the long run. You will undoubtedly experience lower returns than “the market average”.

If your retirement plan is based solely on expected market return averages, you should probably give it a second look.

Imagine a punch bowl with 1,332 little pieces of folded paper, each with one of those market returns. You get to reach in and pull out a number to decide your fate. 650 of the papers represent returns of 6.5% or greater but 682 are less. 78 are less than 4% and 9 are less than 3%.

You get one turn.

But is investing for retirement really as random as pulling a piece of paper out of a punch bowl?


It mostly depends on when you were born.

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