It can be difficult to determine how to devise an investment strategy to help reach your financial goals. To help determine a reasonable rate of return to expect on your stock investments, it might be instructive to review some facts about the stock market:
- The stock market’s historical return can change dramatically depending on the period considered. For instance, from 1926 to 2014, the Standard & Poor’s 500 (S&P 500) had an average annual return of 10.2%. From 1990 to 2014 (25 years), the average return was 9.6% and 7.7% from 2005 to 2014 (10 years).*
- The market tends to revert to the mean. There is a tendency for the stock market to revert back to the average return when it has an extended period of above- or below-average returns.
- History may not be a good predictor of future returns. The expected rate of return for your investment program is typically based on an analysis of past returns, since no one can predict future returns. However, realize that those returns may not be replicated in the future. During much of the stock market’s history, the United States was in a substantial growth phase as it grew from a struggling nation to a superpower. Growth in the future may not approach those levels.
- The pattern of actual returns affects your investment balance. Even if you get the average rate of return exactly right, your portfolio’s balance will depend on the pattern of annual returns during that period. Some years will experience higher-than-average returns, while other years will have lower or even negative returns. If you experience high returns in the early years, your portfolio’s value will be lower than if those returns occurred in the later years. If you encounter negative returns in the early years, you will have a higher balance than if those negative returns came in the later years.
- Historical returns do not include several items that investors must deal with. Two of the most significant items not accounted for in historical returns are inflation and taxes. Over the long term, from 1926 to 2014, inflation averaged 2.9%.* Short-term capital gains are taxed at ordinary income tax rates of up to 39.6%, while long-term capital gains and dividend income are taxed at rates ranging from 0% to 20%. An additional 3.8% net investment income surtax may also apply.
- Investors have a difficult time earning historical returns. Several studies have found that investors’ returns tend to lag the overall market, since investors have a tendency to buy high and sell low.
When designing an investment program, use a conservative estimated rate of return, since it may be difficult to earn the historical returns of the past. It’s easier to start out with a lower expected rate of return and find out later that your actual return is higher, which means you’ll just need to save less.
Consider these strategies:
- Take a fresh look at your financial goals. Reevaluate your goals, how much you need to reach them, and how much you should be saving annually based on lower expected returns.
- Save more of your income. If you can’t count on returns to provide growth in your portfolio, you should compensate by saving more of your income. That may mean you’ll need to work overtime or take on a second job.
- Invest in a tax-efficient manner. Taxes are often a significant investment expense, so using strategies to defer the payment of taxes can make a substantial difference in your portfolio’s ultimate size. Utilize tax-deferred investment vehicles, such as 401(k) plans and individual retirement accounts. Or emphasize investments generating capital gains or dividend income rather than ordinary income. Minimize turnover in your portfolio.
- Adequately diversify your investment portfolio. Typically, you do not know which asset class will perform best on a year-to-year basis. Diversification is a defensive strategy - it may help protect your portfolio during market downturns and help reduce your portfolio’s volatility. Diversify your investment portfolio among a variety of investment categories, such as stocks, bonds, cash, and other alternatives. Also diversify in investment categories.
- Evaluate your portfolio’s performance annually. That way, if returns are lower than you targeted, you can make adjustments to your strategy to compensate for these variations in return.
Please call if you’d like to review your investment program.
*Source: Stocks, Bonds, Bills, and Inflation 2015 Yearbook. 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 returns.