In the investing world, we like to use average annualized returns when discussing the long-term performance of a security or portfolio. It’s certainly not a perfect gauge, but it’s pretty much the best we’ve got.
Investing is not an exact science, so we have to rely on many assumptions and historical evidence to develop a reasonable investment plan. What can we really glean from observing that two years ago the S&P 500 lost around 5%, then the following year made over 30%, and this year it’s down 10%? Only that it’s one volatile investment!
So, we use long-term average annual returns to normalize the return sequence, which helps us develop financial plans and investment portfolios. For example, since 1926 we know that the long-term average of the stock market (S&P 500) is about 10%. But, it may surprise you to know that it’s only come within two percentage points of that long-term average in just 6 of the past 94 years! See chart below:
Stocks are volatile – we know this. But with that volatility comes the opportunity to make great gains. And, overwhelmingly, they make money more often than they lose. You just have to hang on to your hat.
Source: Dimensional Fund Advisors
Mike Minter