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Hey frugal fanatics! Welcome back.
So, something has really been stuck in my craw lately, and I can stay silent no longer! It’s about the average stock market return, and it’s time to drop a few truth bombs ’round here.
I know we don’t talk a ton about hardcore investing topics on this blog, but we do frequently discuss ways to save and make extra money. The fact is, if you want to do both, investing needs to be part of your plan. This is especially true if you ever want to retire.
There’s no denying that investing in the stock market is one of the best ways to make residual income. That being said, it’s important to know what you’re getting yourself into.
Understanding the basics about how the market works, comprehending common terms, and knowing what you’re buying are all crucial to having success. (Psst…this guide to investing for beginners can help!)
But, that’s not all there is to it.
One of the most misunderstood investing concepts is the idea of the annual “average stock market return.” While financial advisors are quick to throw this stat around to encourage investment (and stimulate sales), this metric isn’t the most reliable way to measure your returns. And if you don’t understand it, you might be left wondering why your investments are underperforming.
Frugal fans rejoice! I’m here to clear things up for you.
Whether you’re a new investor or someone who’s already saving for retirement, I’ll help you understand what the average annual stock market return is, why it’s “wrong,” and what you should use to gauge your investments instead. If you’re ready, let’s dive in.
Why You Shouldn’t Expect an Average Stock Market Return of 10%
What if I told you that the “real” average stock market return since 1900 is actually 6.53% per year? You’d probably call me a liar, right?
Well, it’s true.
“Wait, my financial advisor told me that it was over 10%!”
Technically, they’re not wrong. The average return of the S&P 500 over that time period (including dividends) is 11.53%.
But, while true, that statistic is totally misleading. Salespeople are quoting it because it suits their agenda and makes the gains look better than they are.
Average Stock Market Return Examples
So, why shouldn’t you rely on the average annual return metric? Let’s take a look at how average returns are calculated.
To calculate an average annual stock market return over a period of time, take the percentage your investment gained/lost each year and divide it by the number of total years you are considering. Here’s the formula:
Sum of % Gain or Loss / Total Number of Years = Average Annual Return
Example 1: Let’s assume that you invest $1,000. The first year, your money grows by 100%, so you’ve now got $2,000. Pretty great, right? But, in year number 2, it loses 50% of its value. You’re back to the original $1,000…but your average annual return equals 25%. So why is your average return 25% even though you didn’t make any money? Using our formula, here’s the answer:
100% + -50% / 2 years = 25% average annual return
Of course, you know you haven’t made any money; but, if you don’t know how to figure a “true” average annual return, you could easily be convinced otherwise.
Example 2: It’s even worse if you lose money. Suppose you lose 25% the first year. You’d now have $750. If you gained 25% the next year, your average annual return equals 0%. But you’re not back to even. Nope. In reality, you only have $937.50 ($750 x 25% = $937.50). Yikes.
More Reasons Average Returns are Misleading
This isn’t the only reason using average returns is misleading. If you expect a smooth 10% gain year after year, you’re in for a rude awakening.
Unfortunately, the market doesn’t play that game. It can be extremely volatile, especially over the short term. When you look at annual returns for the S&P 500 from 1950 to 2015 (65 years), annual returns have only reached the average 37 times. In fact, it’s actually produced a negative return 15 of those years. That’s a pretty bumpy ride.
You also need to realize that when somebody quotes the average stock market return of 10-12% per year, they’re including dividends but not adjusting for inflation. When you adjust for inflation, the average annual return since 1900 drops even lower, sitting at 8.41%.
How to Calculate the “Real” Average Stock Market Return
You’re probably saying, “There’s got to be a better way to measure my returns over time!”
There is. It’s called the Compound Annual Growth Rate, or CAGR for short.
CAGR is a much more accurate measurement because it accounts for “annualized” growth. Because of that, it fills in the real picture in areas where the average stock market return statistic falls short.
If we head back to “Example 1,”the average return would read 25% while the CAGR would equal 0%. In Example 2, you’d show a 0% average return while the CAGR would equal -3.18%.
Clearly, CAGR does a better job of reflecting your true average of your returns over time. Since the formula for CAGR is fairly complex, I recommend using a good CAGR calculator to figure it out.
CAGR vs. Average Annual Stock Market Returns
So, what is the “real” average stock market return since 1900?
If you’re using a strict average annual return that includes dividends, the average stock market return is 11.53%. When adjusted for inflation, that number drops to 8.41%. But now you know that doesn’t give you the true picture.
When we look at CAGR, we see that the S&P 500 produced a return of 9.70% a year from 1900 to 2015 (including dividends). Adjusted for inflation, the value in today’s dollars drops to 6.53%.
Basically, since 1900, the amount of money you have now grew in value by an average of 6.53% a year when measured in the worth of today’s dollar….and that doesn’t even include the fees you may have paid. Add those in, and that’s what I’d consider the “real” average return on your money.
Instead of looking at the average stock market return, use the CAGR to get the best idea of how well your investments are performing. And the next time somebody tells you the average stock market return is around 10 to 12%, just shake your head and realize you’re being sold.
While the statistic isn’t a lie, it isn’t quite true either. As with all things in sales, scratch a little below the surface and you’ll probably find the true story.