The great stock market myth

"Conventional wisdom" can be misleading. The facts might prompt you to invest differently.

By Charles J. Farrell, JD
Medina, Ohio

Financial gurus keep telling us that over the long run, the stock market provides the greatest consistent financial returns, and that long-term returns average 10.7 percent on an annualized basis. Many investors buy stocks assuming that they'll ultimately earn around that figure.

There's one big problem. It's a myth. The 10.7 percent figure covers the time period from 1926 through 2001, and refers to a compound rate of return over those 76 years.

Most of us, however, do not invest for 76 years. It's important to understand your potential returns over any 5-, 10-, or 20-year period. Because of market volatility, the 10.7 percent average doesn't represent the potential return in any given period. In fact, in any given year over the last 76, the market has performed within one point of that 10.7 percent only 3 times.

If you wanted to invest for 10 years, and started at the beginning of 1990, you did well—earning 18.2 percent. If you started in 1965, you made a paltry 1.2 percent.

Let's look at how actual returns on an investment of $100,000 differed from expected returns based on the 10.7 percent myth. If you had invested $100,000 and received an average annualized return of 10.7 percent for 10 years, you'd have expected to wind up with $276,361. The table below shows how much you'd have if you earned the returns that the Standard & Poor's 500 Stock Index provided in the given 10-year period. The third column shows the difference between what you expected to have at 10.7 percent and what you actually received.

The same scenario holds true over 20-year time horizons. We've all heard the advice, "buy and hold." Many people mistakenly assume that if they keep their money in the market for 20 years, they will get at least the average of 10.7 percent or better.

Not so. If you break the 76 years from 1925 through 2001 into rolling 20-year periods, you get 57 periods. Of those, 22 had average annualized returns of less than 10.7 percent. Returns for the lowest 20-year period were 3.1 percent; the highest was 17.9 percent.

So if you'd started with $100,000 at the beginning of the 3.1 percent 20-year period, you'd have ended up with only $184,508 after 20 years. If you were lucky enough to start at the beginning of the 17.9 percent period, you'd have had $2,679,573. Quite a difference in the value of your account!

Each of us will hit the market at different cycles. Nobody can tell you whether the next 20 years will produce a 17 percent return, a 3 percent return, or something in between. Or even whether your returns will match the average.

If the prospect of long-term low returns gives you chills, you should reconsider how much of your portfolio you keep in equities. You'd be wise to rethink your investment strategy, risk tolerance, and portfolio allocation with this in mind. The smartest course is to position yourself for a range of possibilities. Consider putting a greater portion of your assets into fixed income investments. You'll gain more predictability over some portion of your savings.

You should also save more of your paycheck, because of the stock market's potential to underperform. If the market turns in a lower-than-expected performance, but you've saved more money, you can still end up in the same place. If the market overperforms, terrific! You'll have that much more to live on when you retire.

The author is a financial adviser focusing on investment for retirement.

Charles Farrell. The great stock market myth.

Medical Economics

2002;18:56.