Tuesday, March 01, 2005

Is 10% Realistic...Part III - Vanguard's View

What follows is an article from Vanguard's website which I thought you might find interesting about returns.

The Story

February 22, 2005
'Normal' stock returns are, actually, quite abnormal

It's often noted that the historical average yearly return of stocks is 10%. Paradoxically, this quite-accurate figure isn't the return that most investors are likely to receive in a year.

The 10%-a-year figure is an average calculated over very long time periods, such as the 78 years from 1926 through 2003.* Averages are useful, of course, but you should also be aware of their limitations. Take the extreme example of a desert with freezing cold nights and fiery hot days. An average of the temperatures might show that this desert is quite comfortable.

Stock market returns aren't as extreme as those temperatures, but returns can vary greatly. That's why annual stock market returns matched the 10% average, plus or minus 2 percentage points, in only 6 of the past 78 years, as the accompanying chart shows. And negative returns occurred more often than many investors may be aware: Investors lost money in 24 of the years, or 30% of the time.

Accumulators: Stay focused

By keeping in mind that stock returns can veer widely from historical averages—sometimes for years at a stretch—investors who are accumulating funds for long-term goals may be able to fight the temptation to jettison their investment plan during difficult market periods.

What that 10% figure does mean is that, over the decades, the years of good returns have more than compensated for the years of bad returns. Moreover, for the period 1926–2003, stocks' average annualized return outperformed that of money market investments by about 6.5 percentage points and that of bonds by about 5 percentage points. This difference in returns compounds significantly over time. It's certainly true that past performance is no guarantee of future results. But the historical record does underscore the need to focus on the long term (while also making sure that your asset mix doesn't focus on chasing returns but, instead, matches your risk tolerance, goals, and time horizon).

Awareness that the 10% average is a product of more extreme ups and downs can also help you resist the temptation to overload your portfolio with stocks when the market is way above average—and create a portfolio that may be riskier than you originally intended.

Retirees: Withdraw funds gingerly

For retirees, the challenge is to acknowledge that variable stock market returns, not the steady long-term averages, are the normal state of affairs, and to make their portfolio withdrawal decisions accordingly.

Particularly important is the sequence of yearly returns. A series of good stock market years at the start of retirement can add significantly to a nest egg and make any future bad years easier to bear. But a series of bad years at the start can make it difficult to recoup losses later and can result in a faster depletion of assets.

No one knows what future markets will be like, so retirees should plan to withdraw funds conservatively during the good years and be prepared to modify their spending plans in the bad years. To help put this strategy into practice, Vanguard has developed two portfolio withdrawal techniques aimed at increasing the odds that assets won't be depleted early. They're described in Select Your Withdrawal Method in the PlainTalk® on Managing Your Retirement area.

* The exact average for that time period is 10.4%, based on the Standard & Poor's 500 Index from 1926 through 1970 and the Dow Jones Wilshire 5000 Composite Index from 1971 through 2003. Note that the returns and the principles cited here apply to broadly diversified groups of stocks and bonds and don't take taxes into account. Earnings results for individual stocks or nondiversified portfolios are likely to vary significantly from those shown here.

Scott's Comments:

I think Vanguard is on the right track and providing great education with this piece. I would love to hear your comments.

Till Next Time......