How many times have you read or heard that the S&P 500 returns 10% annually? It’s an easy number to get rid of. However, if this number is wrong, it can have serious consequences for your retirement planning.
Unfortunately, the S&P 500 doesn’t return anywhere near 10% annually. The effective average return — after adjusting for inflation, reinvesting your dividends, and assuming you don’t pay taxes — is about half that.
How is the often quoted number promising at 10% of average annual returns to date? It all comes down to the fact that there are multiple averages, but only one is really important for your ROI.
Explaining the average annual return of the S&P 500
Let’s say you start investing on the first day of 1990 to provide a large enough data set. The S&P 500 closed at 353 in 1989, but climbed over the decades to settle at 3,693 on September 23, 2022. That’s a pretty big jump!
If you calculate the average annual return over that period, you come to 11.1% per year. This is the number you read most often.
It is also meaningless.
The 11.1% annual return is calculated using simple average, or the arithmetic mean. Adds up all annual returns and losses, then divides by the total number of years in the data set. This is not how you accumulate your money.
To illustrate, let’s say you’ve been an investor for two years. In the first year you earn 100% return. In the second year you lose 50%. The simple average tells us that your average investment returns are 25% over your two-year career. However, you actually have the same amount of money you started with, which means you have a 0% return.
This is because your money is multiplied by using geometric meanwhich is more commonly referred to as the compound annual growth rate (CAGR).
Let’s review the example above. If you started investing on the first day of 1990, then by now you will have:
- Simple average return of 11.1%
- Compound annual growth rate of 8.1%
- Compound annual growth rate of 4.6% rate of inflation
- A compound annual growth rate of 5.3% adjusted for inflation and assuming you reinvest all profits
- All rates assume that you did not pay any taxes on your returns
This is a mind boggling thing, isn’t it? That’s basically half of the 10% annual return figure that gets thrown around too lazy. There are consequences to oversimplification.
If you assume that you will earn an annual return of 10% for 40 years, your initial investment will grow by 4,426%. If you assume that you will earn an annual return of 5.3% for 40 years, your initial investment will grow by 689%. This makes a big difference in retirement planning.
Are there lessons in the data?
The starting year affects the long-term compound annual growth rate (CAGR). Generally, you will earn lower long-term returns for the money invested in peak market periods and during multi-year recessions.
Consider S&P 500 returns through September 23, 2022 when adjusting for inflation, assuming you reinvested all dividends and paid no taxes:
- A compound annual growth rate of 2.7% from the first day of 1999, which was the end of the dot-com bubble
- A compound annual growth rate of 2.2% from the first day of 2000 which was the first correction year after the dot-com bubble
- A compound annual growth rate of 2.8% from the first day of 2001
- A compound annual growth rate of 3.6% from the first day of 2002
- Compound annual growth rate of 5.0% as of the first day of 2003
For historical context, the S&P 500 rose by a double-digit percentage for five consecutive years starting in 1995, but then fell by a double-digit percentage for three consecutive years starting in 2000. It was a brutal stretch.
The strength of hindsight offerings sitting on the sidelines and jumping back in during 2003 would have resulted in high long-term returns two decades later. Given that we may be entering a similar period as the markets correct the 2020 and 2021 excesses, the best approach to preserving capital may be to sit on the sidelines. This is so amazing to me!
The challenge with this approach is knowing when to come back. For most retail investors, it is impractical to make sudden changes in their exposure to stocks. The next best strategy is to make consistent contributions to your portfolio over an extended period of time, ensuring that you buy stocks in good times and bad. Then again, the numbers above simply use the first day of the calendar years – there is no timing. Perhaps it would be best for retail investors to return in full on the first day of 2024 or 2025.