Over time, stocks outperform nearly every other asset class.
An ongoing data project by NYU’s Stern School of Business showcases how much money a fictional (and long-lived) person would have each year if they invested $100 in 1928.
If they’d invested $100 in U.S. Treasury bonds, by the end of 2020 they would have $8,920.90. If they’d invested that $100 in corporate bonds, they would have accumulated $53,736.50.
But if they’d invested in an index fund mirroring the S&P 500, they would have $592,868.15. That’s more than 11 times more than if they had invested in corporate bonds and nearly 66 times more than if they had invested in Treasury bonds.
Stocks offer higher returns than most assets, but they also come with higher volatility. Still, investors looking to capitalize on stocks’ high historical average returns can combat the risk with knowledge and sound financial planning.
Average Returns From the S&P 500
It was surprisingly difficult to run accurate numbers on the long-term average return on the S&P 500.
Even finding accurate data proved a challenge, although a combination of data from Yale economist Robert Shiller and Yahoo! Finance provided sufficient information in the end.
The takeaway: Since 1927, the S&P 500 has returned around 10% annually on average, including dividends but not adjusting for inflation. However, that figure could use quite a bit more explanation.
It’s worth mentioning that in the 1920s, the S&P index only included 90 stocks. In 1957, Standard & Poor’s expanded the index to include 500 companies. With that understanding, for simplicity, we’ll use the term “S&P 500” here to refer to the U.S. stock market index.
Note that the S&P 500 makes a better benchmark for U.S. stocks than the Dow Jones Industrial Average because it includes 500 of the largest companies in the U.S. rather than just 30.
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Annualized Returns
When you look back over historical returns of the S&P 500, each year’s price growth only reveals part of the story.
You can’t just average each year’s returns. For a quick example, imagine you invest $10 in a stock and it rises by 100% in Year 1, doubling to $20.
Then in Year 2, it falls by 50%, dropping back to exactly where it started. If you averaged 100% with -50%, you’d come up with an average return of 25% — even though the stock actually returned 0%.
Instead of simply averaging percentage returns, you have to calculate something called Compound Annual Growth Rate (CAGR), which involves calculating a geometric mean rather than an arithmetic mean. See Morningstar’s explanation if you’re interested in the math.
For example, when I calculated the arithmetic mean of each year’s return from 1927 through 2019, the result was 12.16%. But the actual CAGR, or average annual return, was 10.21%.
This average includes dividends, not just price appreciation, to represent the total return.
Reinvested Dividends
The yield from dividends represents an important part of stock market returns. Over the decades, the dividend yield of the S&P 500 index has largely hovered in the 2% to 3% range, although at times it exceeded 5%.
When investors reinvest those dividends back into their holdings, the yield compounds over time to generate far higher returns. Without reinvesting dividends, the S&P 500 only returned 6.07% annual returns on average.
A word to the wise: Automatically reinvest your dividends.
Inflation
Inflation is your money’s silent killer.
A dollar in 1927 was worth nearly $15 in today’s money, according to the BLS inflation calculator. Parking your money in a savings account, even a high-yield savings account, likely means losing money over time to inflation.
That’s why you need to invest your money, not just save it.
Average inflation falls in the 1% to 5% range per year, although like stock returns, it fluctuates wildly. In 1980, for example, inflation grew at a dizzying 18%.
When you adjust for inflation, the S&P 500 has returned 7.08% on average since 1927. That still beats the heck out of most alternatives.
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Stock Returns Vary by Region & Index
Just because U.S. large-cap stocks in the S&P 500 have returned around 10% per year since the 1920s doesn’t mean every single stock index in every country has performed identically.
For a terrifying example, look at Japan’s Nikkei index. It peaked in 1989, then collapsed and never recovered. In early 2020, it still sits around 50% lower than its 1989 zenith.
Even so, stocks in developed countries worldwide have had returns similar to the S&P 500 for well over a century.
A joint study by the German central bank and several U.S. and German universities analyzed long-term returns among stocks, rental real estate, long-term bonds, and short-term bills during the period from 1870 to 2015.
After adjusting for inflation, they calculated the average stock returns across 16 countries at 6.89% — remarkably similar to the S&P 500’s 7.08% inflation-adjusted returns.
“Average” Doesn’t Mean “Regular” or “Predictable”
Rarely do stocks smoothly rise upward by 10% in a given year. Instead, they fall sharply one year and then come roaring back the next, or vice versa. In 2018, the S&P 500 lost 4.41%, The following year, it gained 31.10%.
Stocks do provide strong long-term average returns, but they do so on their own terms, moving in fits and starts, leaps and nosedives.
As a stock investor, you need to embrace the volatility and accept that you may lose 30% one year, knowing that you may well earn 40% the following year.
The problem is that while many investors think they can handle the volatility, most succumb to herd psychology and emotional investing when stocks perform exceptionally well or poorly.
Emotional Investing & Underperforming Stock Index Averages
While the S&P 500 lost 4.41% in 2018, the average investor lost more than twice that. According to analytics agency DALBAR, the average investor lost 9.42% in 2018 because they let their emotions get the better of them.
U.S. stock markets had enjoyed several strong years of growth leading up to 2018. Investors started getting greedy, forgetting that markets move down as well as up. Then a stock market correction hit in 2018, and many investors panicked and sold after stocks had already fallen.
The market hit a bottom as it always does, and then it rebounded, but by the time all these jittery investors felt confident investing again, the rebound was already well underway.
In other words, they sold low and bought high.
Unless you day trade for a living, invest for the long term. Don’t dip in and out of the market, following the herd.
Tips to Earn the Average Index Returns, Not Average Investor Returns
Average investors didn’t underperform the market only in 2018. That year was no outlier.
Another report by DALBAR found that from 1996 to 2015, the average investor earned only 5.19% per year. Yet the S&P 500 returned a historically normal 9.85%.
If you want to remove emotion from your investing and earn higher returns, try implementing the following investment practices.
Dollar-Cost Average
Most investors make the mistake of trying to time the market. That usually means they buy when they see the stock market already going up and sell when it’s already going down.
Instead, just invest the same amount on the same interval into the same investments.
For example, every week, invest the same amount in an index fund that tracks the S&P 500. Over time, your returns will mirror the index almost exactly.
Automate those investments using either a human broker or a robo-advisor. That proves another advantage of dollar-cost averaging: you can set it and forget it.
Don’t Sell Outside of Your Core Investing Strategy
The average investor underperforms the market largely because they panic sell.
How can you avoid this? Don’t sell outside of the regular rebalancing, tax-loss harvesting, or tweaking your asset allocation as you age.
Leave your money in long-term investments, and don’t flit in and out of the market. You only earn the long-term average if you buy and hold, not by allowing jitters or greed to alter your core investing strategy.
Diversify Your Stocks
Buying shares in index funds inherently helps reduce your stock investing risk through diversification. Instead of owning one stock, you own hundreds or even thousands, without relying on expensive mutual funds.
Don’t stop at just one index fund, though. I recommend at least three ETFs: one U.S. large-cap index fund, one U.S. small-cap fund, and one international stock fund.
You don’t have to pick these funds yourself or hire a pricey financial advisor. Choose from among the best robo-advisors out there and open an account to gain access to cheap — in some cases free — investment management and advice.
I use Schwab Intelligent Portfolios, which is free, but SoFi Invest is also free, and Betterment offers a low-cost but balanced option as well. Another option is Ellevest, which was built by women for women.
Retirement Planning, Stocks, & Volatility
When you’re young, you have the luxury of time to invest long-term and not worry about stock market corrections or bear markets.
As you near or reach retirement, reliable income takes a more important role in your investments over high long-term returns.
But that doesn’t mean you should abandon stocks entirely. Instead, plan your retirement strategy and stick to it, just like you do in every area of your personal finances.
Safe Withdrawal Rates
If you’ve ever heard of the 4% rule, then you know the concept behind safe withdrawal rates.
This rule is an attempt to answer the question of what percentage of your portfolio you can pull out to live on each year in retirement without running out of money.
Following a 4% withdrawal rate, for example, you would withdraw 4% of your nest egg in the first year of retirement, then raise that amount slightly each year to account for inflation.
Considering average stock market returns, that makes sense. If stocks return around 10% per year as a long-term average, and you only withdraw 4% per year to live on, then your nest egg should theoretically keep growing forever at an average rate of 6% per year.
It sometimes works out that way in the real world, but not always. Retirees face a unique risk: that a stock market crash early in their retirement wipes out too much of their nest egg to ever recover.
Sequence of Return Risk
While you’re working and funneling money into stocks, your long-term average returns are all that really matter.
That changes when you retire and the order, or sequence, of your returns starts to matter, not just the long-term average.
A market crash early in your retirement causes far more damage to your portfolio than one later in your retirement. This is known as sequence of returns risk. A crash early in retirement can devastate your nest egg.
Conventional wisdom from investment advisors suggests that you gradually shift away from stocks and toward bonds as you get older.
As a rule of thumb, advisors recommend you subtract your age from 100, 110, or 120 to determine the ideal percentage of stocks in your portfolio.
Risk-averse investors should use 100 minus their age, while those favoring higher returns should use 120 minus their age.
The remainder of your portfolio can go into income-oriented investments such as bonds or low-risk real estate investments.
I personally opt for real estate over bonds, including both rental properties and indirect real estate investments. I’ve had success with Fundrise and Streitwise as sources of passive income, but do your own research to determine what’s best for you.
If you do stray from low-risk, low-return government bonds in retirement, make sure you speak with a financial advisor about risk management. Your contingency plans should have contingency plans.
Final Word
Over the long term, no investment class has beaten stocks, with the possible exception of rental real estate (see the joint German-U.S. study above).
Yet the average American fails to benefit from stocks’ high average returns for two reasons.
First, only around half of Americans even invest in stocks. Second, among those who do, many allow emotion to affect their investments, with psychologically driven trades cutting their returns in half.
Fortunately, investors today have access to automated investing tools like robo-advisors to help them eliminate emotion from their investing decisions and put their investments on autopilot. With free robo-advisor services and commission-free trades, automated investing can cost literally nothing.
No investment portfolio is complete without some exposure to stocks, but the ideal percentage in your asset allocation mix varies based on your age, goals, and risk tolerance.
If you’re new to stock investing, consider opening an account with a robo-advisor and take advantage of tax-sheltered retirement accounts such as an IRA or 401(k).
Capitalize on compounding stock returns while you’re healthy and working so you can afford to stop working sooner rather than later.
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