There's a common rule of thumb that stock portfolios should return 10 percent per year. Although it might not be far from the truth, it's also not exactly right. It's like saying you get from Los Angeles to Atlanta by going east -- there are a few important details missing. Ultimately, although 10 percent is a good target, your desired return is going to vary depending on how long you have to invest and the types of investments that you make.
Over a very long period, the stock market does very well. For instance, over a 20 year period from 1993 through 2012, the S&P; 500 stock index posted an average annualized return of 8.22 percent. A dollar invested on Jan. 1, 1993, would have been worth $4.85 at the end of 2012. Over a longer period, for example 1973 through 2012, the return was 9.78 percent, turning a dollar into $41.82. On a 100-year horizon, the return was 9.75 percent, and a dollar would have turned into $10,933.70.
There are ways to interpret returns, though, to make them say what you want. For instance, if you just average the annual returns of the stock market, you won't be taking into account how price fluctuations affect your money. For instance, if you have $1,000 invested and the market loses 50 percent then gains 50 percent, the arithmetic average would be 0 percent. However, your $1,000 investment would actually go down 50 percent to $500, then the $500 return would go up 50 percent to $750. The compound annual growth rate, also known as an annualized return or geometric average, takes this into account.
Stock market returns also aren't as high as they seem because of inflation. When a dollar turns into $1.10, you might have 10 percent more money in your account, but you usually won't have 10 percent more purchasing power. As a drastic example of this, a dollar invested in the S&P; 500 for the 100-year period between 1913 and 2012 might turn into $10,933.70, but when you adjust for inflation, the return drops to $461.92 -- 6.33 percent. The return for the period from 1993 to 2012 goes down to 5.65 percent, and a dollar would only triple after inflation.
Risk vs. Reward
One of the two biggest factors in your return from the stock market is your risk level. If you buy a "safer" basket of investments, your return will be lower but the chance of not hitting that return goal also will be less. Buying riskier investments should increase your returns, but it also carries a greater chance that you won't hit that return at all. Diversifying, which you can do by buying smaller pieces of more assets instead of bigger pieces of fewer assets, tends to reduce risk. If you buy 1,000 shares of one stock, it could do really well or really poorly, but if you buy 100 shares of 10 stocks, it's likely that a few big winners will balance out a few big losers.
The amount of time you have to invest in the market also affects your return. Adding time is like diversifying. Although diversifying gives you more assets to make up your overall return, adding time gives you more good years to balance out your bad years. For instance, the average rate of return, not adjusted for inflation, between 1993 and 2012 was 8.22 percent. However, that 20-year period included six years in which the market lost money, and 14 years in which it was up. In the worst year, 2008, the market lost 37.28 percent of its value, while in the best year, 1995, it gained 34.6 percent. Interestingly, only two years during that period had returns that were anywhere near the overall rate of return -- 1993 and 2004. As such, the amount of time you spend in the market also affects your overall return and your ability to predict it.
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