Do you remember the course you took back in high school, or maybe your freshman year of college, that taught you about how to manage your personal finances and invest your money?
If you’re thinking something along the lines of, No, I never took a class like that — that kind of class doesn’t exist! then rest assured: That’s how 99% of people would likely answer this question.
The fact is, we don’t receive this kind of education in schools. Rarely do we get it from our parents either, and our friends or co-workers aren’t much help because they’re in the same boat.
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The Importance of Earning an Objective Financial Education
Learning about how to invest and how markets really work is critical — and yet most people have zero formal training or education on these topics.
Even if you do get proactive and set out to teach yourself all there is to know, you’ll run into yet another challenge: There is no end to the misinformation out there. While the internet is an incredibly helpful tool for learning, it has that one big downside of not being able to filter through the noise. The signal can be hard to find. It’s even more difficult to know fact from fiction.
That’s part of the reason why investment education is one of the first tasks I tackle with someone when we first begin working together. We sit down and look at the facts and evaluate the best strategies to use to earn a reasonable investment return.
What Should You Expect from Your Investment Return?
Some people come to me thinking that it’s reasonable to expect a 30% gain in a single year, because So-and-So at a friend of a friend’s dinner party was talking about it. Others have intense fears of losing everything should they dare dip a toe into the waters of the market.
In either case, both thoughts are far from reasonable. They’re highly emotional and, as in most cases, based on fear: The first comes from the fear of missing out on something spectacular, and the second comes from fear of loss.
Regardless of how you might currently approach investments — whether through extreme fear or by being irrationally optimistic — getting some historical context about how the market tends to work over time can help set realistic, rational expectations for your investment returns.
What Historic Investment Returns Can Tell Us
Let’s start by looking at some historical, average real returns. From 1900-2014, the real returns (“real” means these numbers take inflation into account) for the following three types of investments are:
- Stocks 4.8%
- Bonds 0.7%
- Cash -3.9%
These numbers come from Meb Faber’s whitepaper, Global Asset Allocation (a great resource for further reading on this topic).
Do these numbers seem a bit low to you? Again, that’s because they’re adjusted for inflation. Without making this adjustment, each return would be roughly 3 to 4 percentage points more than what’s listed here. That would give you what’s called nominal return.
What do these numbers tell you? Take a look at what cash returned. Historically, to keep pace with inflation and avoid losing value, your cash would need to stay in a savings account that offered you at least 3.9%. Anything less, and your cash loses purchasing power over time.
Of course, when you consider that the best interest rates you can get on savings accounts right now run about 2%, you start to see the problem with stuffing your cash under your mattress (or even into an FDIC insurance bank account).
Despite inflation being historically low, hovering around 2.2% right now, cash today still provides you with a negative 0.2% real return. That’s historically above average, but staying completely in cash will still erode your wealth!
Investing in a strategic way to meet your goals is important. If you’re keeping all your money in cash because you’re afraid of losing it all in the market, it’s time to acknowledge you’re still taking on risk by avoiding investments.
The Trouble with Averages (and Why You Shouldn’t Expect Them)
None of this is to say that investing in a stock and bond portfolio will guarantee you a return. The average real return of stocks over time might clock in at around 4.8% — but that is no guarantee of what will happen in the future, or in your particular situation.
Here’s the issue: You can’t just take this average and assume that’s what you’ll earn every year. Rarely does any asset class hit its average investment return year after year.
In fact, depending on when you started investing, it can sometimes take decades to get your returns to these levels. That might sound scary, but you actually have a secret weapon, should you choose to use it: Time.
You can earn a reasonable average return, like the ones listed above, but you have to give your investments time to get there. The longer you invest in the market and stay in the market, the better your chance of earning the average investment return.
This phenomenon is called reversion to the mean. Here’s how Don Bennyhoff, Senior Investment Strategist at Vanguard, explains this:
“In only two years out of the last 80-odd years have returns of the stock market and the bond market both fallen within a close approximation of their long-run average. So, returns are rarely normal, and yet most people kind of use that as their base expectation of what should I be expecting from my stock and bond portfolio.”
In other words, your investment return in any given year is unlikely to reflect the average return your portfolio gives you over time.
You also have to keep in mind that these returns come from broad-based indexes that track large segments of the market. If you own only a few stocks or only a few mutual funds, you can have returns that fall substantially outside of these norms (which is a great reason to ensure your investment strategy keeps you well-diversified).
Having proper expectations of what markets typically return can only help you invest properly, as determined by your goals, needs and ability to handle risk. You can’t control the market — but you can control your expectations by diversifying and investing in a portfolio that is allocated toward the risk you can handle.
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