This is a guest post from Carl Richards at Behavior Gap. It's based on one of my favorite posts at his site, and is a terrific complement/counterpoint to my article on how much the stock market actually returns. As he points out, average returns are not normal.
On average, stock market returns are higher than inflation, money markets, or bonds. Understanding this is an important step to any successful financial plan, but there is a huge difference between “average annual” and “every year”.
Many of the commonly-used approaches to financial planning take long-term average rates of return and then make the assumption that you will get that return every year. Say you build an investment portfolio that you think will have an average return of 8.5%. Just because the average is 8.5%, it should be obvious to anyone that has been alive the last 12 months that this does not mean we will get 8.5% every year.
While this may seem obvious, the implications are huge.
Let's walk through two hypothetical examples. In both scenarios that follow assume:
- They start with the same amount of money.
- They add the same amount each month.
- Both investments have the same average rate of return.
Scenario One: Bad Years First
You start with a small initial investment and then do the right thing by adding money each month. You feel like you are throwing good money after bad because each month your statement arrives and it is lower. But you continue to accumulate shares of the investment. After years of “bad” performance you have built up a sizable portfolio and the market turns, and you have years of “above” average returns. In this case the “good” returns came at the time when you had the most money to benefit from them.
Scenario Two: Good Years First
On the other hand, you could spend years adding to your portfolio every month and be very excited because the investments you have chosen perform really well right from the start. You have a bunch of “above average” returns for the early years when you don't have a lot of money at risk. Then as you get more money “at risk” you have the normal cycle, and your investment is down for a few years. Here the “bad” returns came at the time when you had the most money at risk.
So both investments have the same rate of return, but the investor in scenario one ended up with more money.
Your investment return is only one part of the equation in a financial plan. (The other part is your life.) Because average is not normal, it is important to view financial planning as an ongoing process, and not a one-time event that assumes that we will receive that “average” rate of return.
Read more about how human behavior influences investment returns at Behavior Gap. If you liked this article, check out the companion piece at I Will Teach You to Be Rich (one of my favorite personal-finance blogs).