When setting up an investment program, the assumed rate of return is typically an average annual return for some historical period. While that is generally viewed as a conservative approach, there are some issues with this approach:
- Average returns are an average of past returns and do not indicate what will happen in the future. Economic and market events may or may not replicate past events.
- The average annual return can vary substantially, depending on the historical period used. For instance, from 1926 to 2005, the Standard & Poor's 500 (S&P 500) had an average annual return of 10.4%. From 1986 to 2005 (20 years) the average return was 11.9% and 9.1% from 1996 to 2005 (10 years).* Those differences in average return would project a substantially different ending portfolio value over an extended time.
- The average return does not reveal the pattern of returns over that period. Some years will experience higher returns, while other years will experience lower or even negative returns. Even if you select an average return that is exactly right, your portfolio's ultimate balance will depend on the pattern of returns over that period.
- Most people don't just allow a lump sum to grow, but make deposits and withdrawals over the years. Since your actual return fluctuates from year to year, your pattern of additions and withdrawals can also significantly impact your portfolio's ultimate value.
While it is instructive to consider average returns when developing an investment program, you can't simply project that return into the future. Instead, consider these steps when deciding on an estimated rate of return:
- Evaluate your expectations for future returns against historical averages. It may be prudent to assume lower returns in the future. It is easier to save less if you obtain higher returns than to try to save more over a short time period if your actual return is lower.
- Consider a range of possible returns for your portfolio. What would happen to your portfolio's balance if you earned your expected return, 1% less, 2% less, etc.? This analysis can help you determine what adjustments would need to be made to compensate for lower returns.
- Review your progress every year. This will allow you to make adjustments along the way, so that those adjustments can be gradual. If your return is lower than expected, you may need to increase savings or change investment allocations.
The expected rate of return used in your investment program is an important component in determining how much you should save to work toward your goals. If you'd like help evaluating an appropriate expected rate of return for use in your investment program, please call.
*Source: Stocks, Bonds, Bills, and Inflation 2006 Yearbook, Ibbotson Associates. The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market. Investors cannot invest directly in an index. Past performance is not a guarantee of future results. Returns are presented for illustrative purposes only and are not intended to project the performance of a specific investment.