The illusion of an easy or surefire investment appeals to everyone. The same goes for investment planning. We often look for “rules of thumb” in areas where we have little knowledge or interest. When it comes to returns, many investors use this rule-of-thumb thinking to ask about average returns or the kind of returns they can expect.
You might ask, “What’s wrong with that? It’s good to have a benchmark!”
But there are hidden dangers in aiming for “average returns”. Consider this before you base your investment strategy on “averages” or “rules of thumb.”
First and foremost, past performance is no guarantee of future results. That means you should take any such assumptions or predictions about returns with a grain of salt.
To wit, you may have heard that stocks have historically averaged a 10 percent return. That rule of thumb reflects the annual return of the S&P 500 from 1926–2018. However, there are a lot of caveats in there. For instance, the S&P 500 only took on its modern form (tracking the top 500 U.S. companies) in 1957. Returns since then are roughly 8 percent. And according to data analyzed by NerdWallet, between 1926 and 2014, stocks only returned 8–12 percent (the “average” range) SIX times. That means the 92 other years saw returns lower than 8 percent or greater than 12 percent.
And those divergences are just looking at the S&P 500. When you add international stocks, like the Russell 5000 (looking at smaller companies), or even other asset classes like bonds to the mix, you get even more factors affecting those “average” returns.
Your portfolio returns
I once had a client tell me she was a conservative investor. Yet, she expected a 10 percent return. As you just saw, however, that 10 percent came from the all-stock S&P 500, which is not a conservative investment profile. Plus, the average investor typically does not make the same returns as the S&P 500, for a variety of reasons. Namely, many investors spend their time trying to “beat the market” or the S&P 500 in any given year.
Plus, some investments can’t be averaged properly. For instance, the average rate of return on a changing portfolio might fall not because the investments are performing poorly, but because the investor decided to switch to less risky investments that naturally return less.
The above scenario is actually quite standard. Young people invest in riskier assets because they have time to ride out those ups and downs in the stock market we outlined above. But investors near retirement don’t want to risk their nest egg on a bad year for stocks.
This is all to say, a conservative investor shouldn’t be targeting the return profile of the S&P 500, she should be targeting the returns needed to reach her goals. If those goals are retirement, she may not need 10 percent returns. And she may not want the risk associated with that “average.”