February 20, 2009

The Truth about stock market returns


If you had $100 to invest in the DOW in 1928 you would have $3128.52 today- what a deal right? Wrong, let me tell you why.


I've been to several financial offices where they proudly display the graph of the DOW since 1928. The desired effect being that we are to think that the market always goes up, you just have to be patient. I, like many people, didn't appreciate just how patient one has to be though until I examined the returns in more detail.

Lets work through the numbers. If I had invested $100 in an DOW index fund in 1928 as the market was starting to fall apart (yes I know they didn't exist but it serves our purpose well and I think you understand the intent) and left it there I would have had $3128.52 Feb 2, 2009. But who can wait 80 years for a return- not me, that is more than a lifetime.

The mind naturally assumes though that if I waited half of that time I should have approximately (give or take 10%) half of that return so somewhere around $1562.76- that is a pretty good return for 40 years. So does that hold up?

Sadly no, you would have a paltry $339.26 40 years after the initial investment, nowhere near our goal. But, you might say, 300% return in 40 years is still a pretty good return, not as good as what we see at 80 but I still like it. In the big picture though a 300% return over 40 years is really not that great- that is a long time to wait for 300%. So we hack it down again, could I get 150% in 20 years, I am patient enough to wait 20 years for 150% so how about $300 in 1948? Well how would you feel about $69.31 instead?

The reality of it is compound interest can help you or really hurt you. 10% return one year and a 5% loss the next year is not the same as two 5% gains.



InvestmentY1 RORY1 NetY2 RORY2 Net(Compound)
$1010%$11.00-5%$10.45
$105%$10.505%$11.03
Interestingly enough if instead of investing our money in the market in 1928 we had found a stable bank that could return us a paltry .31% on our investment compounded monthly, or 3.72% per year we would have a higher return on our investment from the bank account than the DOW almost every month until February 1987, some 59 years after the initial investment.

The point I am trying to make is simply this, the bad months can do incredible damage to your portfolio in the long run. Be wary of investment systems that advertise an average made up of huge gains, and substantial losses. Those losses may hurt you more than you might first think. Stability and consistency of returns wins the race in the long run.