We've all heard that if we invest money in the stock market, that we can earn 10-12% returns, right? If that's true, then someone investing $10k per year at an annual average return of 11% would have a little over $700k after 20 years. Not bad. Unfortunately, it's not quite that simple or easy. Here are some reasons why you can't count on that 10-12% return:
"Average" Returns vs. "Annualized" Returns
The first problem is the use of "average annual returns," which the financial industry often uses to make past returns look a little better than they actually were. This number is calculated by simply taking an average of annual returns over a given period. [More from Forbes: 10 bizarre investment strategies]
Let's say you owned a single stock that was valued at $100 and the market increased by 100% in the first year and lost 50% in the next year. 100% minus 50% divided by 2 would give us a 25% annual average return and we would expect our value to be $125. But in reality, the $100 would have gone up to $200 ($100 plus 100% increase) and then dropped back down to $100 ($200 reduced by 50%), leaving us with exactly as much money as we started with for a 0% return.
The more volatile the returns are, the more distorted the numbers will be so this is an extreme example but even a small difference in returns can have a huge impact. For example, according to this web site, the average annual return of the S&P 500 (including dividends) was about 9.6% from 1992-2011. However, the compounded annualized return (what you actually earned once volatility was factored in) was about 7.8%. That might not seem like a big difference but $10k a year over 20 years at a 9.6% return is about $600k. At a 7.8% return, it's a little over $480k. That's almost a $120k difference. Over a longer time period, the gap would only continue to grow.
Lump Sum v. Systematic Investing
But wait, it gets worse. Both the average annual and the compounded annualized returns are based on investing a lump sum of money at the beginning of 1992. That works great when you invest in the middle of a long term bull market but not so great when you're investing over time into a market with lower returns near the end of the last 20 years as most people have actually been doing. After all, a lot of your money never got to experience the bull market that ended in 2000. [More from Forbes: The 20 new rules of money]
ow much of a difference would that have made? According to the latest Dalbar report, someone investing systematically from 1992-2011 would only have earned about a 3.2% compounded annualized return compared to the 7.8% return if they invested all at once in 1992. At that 3.2% return, our $10k a year would have actually grown to only $280k.
This assumes we continued investing the same amount through thick and thin. If we panicked and stop contributing or even bailed out of the market during the downturns, our returns could have been even less. A recent Fidelity study showed that investors who got out of the market during the 2008 financial crisis only earned back 2% of their portfolio as of the middle of last year while those who stayed the course, earned back 50%. Those who continued contributing did even better, earning 64%, while those who stayed invested but stopped contributing earned 26%.
Mutual Fund Fees and Trading Costs
Of course, you can't invest in the S&P 500 directly. At the very least, you'd have to pay commissions to purchase each stock and most people invest in stocks through mutual funds, which charge all kinds of fees. Let's assume that you don't buy a load fund from a broker or pay a management fee to an investment advisor and just focus on the expense ratio, which is a measure of the annual fees charged by the fund. Last year, the weighted average expense ratio of actively managed mutual funds was .93%. Most actively managed funds underperform the market but we'll be generous and assume you invested in a fund that did as well as the S&P 500 minus that .93 fee or 2.27%. In that case, your $10k a year would have grown to $252k after fees. [More from Forbes: 10 hot rocks for your portfolio]
It also doesn't factor in hidden costs that can be incurred every time a fund buys and sells a stock. There's the bid-ask spread or the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept. In addition, when a large fund makes a trade it can push the price of a stock higher when it buys and lower when it sells.
Don't forget about your silent investing partner. In taxable accounts, Uncle Sam will want up to 15% of capital gains from the sale of stocks held over a year and on qualified dividends you get each year. If you held the stock for less than a year, then any gain on sale will be taxed at your regular income tax rate, which could be up to 35%. This is on top of any state or local income taxes.
Prospects for the Future
Many experts fear that stocks returns could be lower going forward. Stocks tend to do well when interest rates are coming down but they're already near historic lows and could rise if the economy improves or the Fed sees signs of rising inflation. Stock prices are also a function of supply and demand and that demand could lessen as retiring Baby Boomers stop investing and start selling stocks for income or shifting assets into more conservative investments like bonds and cash. Finally, there are the geopolitical risks inherent in a global economy. [More from Forbes: World's riskiest debt in pictures]
At the same time, taxes may be raised to pay for our growing national debt and entitlement obligations. Unless the law is changed before the end of the year, the maximum rates on investments are already scheduled to increase to 20% for capital gains on stocks held for at least a year and 39.6% on dividends and short-term capital gains. In addition, a new 3.8% Medicare tax on net investment income is set to take effect next year for higher income individuals.
What Can We Do?
The answer is not to abandon stocks altogether. After all, we still have to invest our money somewhere. Short term savings instruments like CDs and money markets accounts are paying next to nothing. Long term bonds aren't paying much more and would fall in value if interest rates go up. Gold is currently priced relatively high and has a poor long term track record. There's also no proven method of timing when to get back into the stock market.
For these reasons, stocks are still our best long term prospect for at least a portion of our portfolio. There are some steps we can take though. We can use Roth accounts and tax minimization strategies to reduce the impact of taxes on our portfolios. We can pick funds with low cost and low turnover like index funds. We can diversify internationally into countries with younger populations. We can avoid selling and continue investing when the market is down. [More from Forbes: 5 places for your cash instead of money markets]
But most importantly, we can assume a lower return into our planning calculations. Instead of an 8-10% return, we might want to plan on a 6-8% return. Yes, that means we'll have to save more to achieve our goals. If the stock market ends up doing better than expected, then you can retire earlier, have more income in retirement, and/or leave more money to your heirs. Either way, you'll be glad you saved more when you could.