Stock Market Average Annual Return

Looking at the averages can be misleading forWhen the returns in a series of numbers become
followers of baseball as well as investing. Yourmore dispersed from the average, the compound
team’s batting average may be the best inreturn declines. The greater the volatility of
the league until they encounter the pitcher withreturns, the greater the drop in the compound
the best Earned Run Average (ERA). Investorsreturn. Some examples will help to demonstrate
who expect to receive the stock market averagethis phenomenon. The table below shows five
annual return each year will be disappointed.examples of how the dispersion of returns
Many investors take it as truth that October isaffects the compound rate.
the worst performing month of the year. YetIn each case, the simple average is 10%, while
looking at the average monthly returns for thethe compound average declines as the dispersion
stock market back to 1926 and it turns out thatof returns widens. In each of the last two years,
September has historically been the worst month,the market experienced losses. A loss widens the
with an average return of -0.75%. Just like thedispersion of the return, which lowers the
best hitting team that encounters the bestcompound average.
pitcher, September 2009 ignored the averages
and turned in a respectable 3.7%. You cannotHalf the time the stock market moves up or
count on the averages being right every time.down by 16% or more in a year. Think back to
Speaking of averages, according to variousthe returns we have seen in the market over the
reports the stock market average annual returnlast few years. They more closely reflect years
is approximately 8% over the 81 years ending inof positive and negative returns similar to
2008. Many mutual funds and investment advisorsExamples 4 and 5.
like to use average annual returns, as it allowsNegative Returns
them to use a higher number. When confrontedAnother consequence of losses in the market is it
with this situation ask them is that the simpletakes a much greater return to recover to where
average or the compound average. It makes ayou began. If you earn 10% in the first year and
difference, as the compound average is aboutthen lose 10% in the second year you still have a
7% and is the more relevant number as we willloss over the two years as the first example
discuss shortly. Many investment advisors useshows. Moreover, if you lose 50% in one year,
average stock market returns to convince theiryou must generate a 100% return to just
clients to invest with them in the market. Thebreakeven. A very difficult proposition.
problem is not every year delivers this average
return. A history lesson might be in order.Therefore, the message is to be very careful and
In the last 83 years, the stock market lostnot lose money. When you do, you must
money in 28 of those years. Even worse, it lostgenerate greater returns to break even, let alone
more than 20% in eight of those years and fourmake any money. No wonder Warren
different times the market fell one-third duringBuffett’s first rule of investing is do not lose
that year. Ouch.money.
When looking at the stock market average annualThe Bottom Line
return there are several important factors toIn baseball, your hitting average does not tell the
understand. One is the affect of the dispersionentire story. The same is true with investing. Be
around the mean. The second is how negativecareful when listening to those who espouse they
returns, i.e. losses, really hurt your return. Theare beating the stock market average return.
calculation of average annual returns does notMoreover, keep your losses small. When you
take into consideration the affect of these twohave gains, be sure to protect them. That way
factors. The compound return includes them soyou make compounding averaging work for you
the number accurately reflects the return youand you will experience positive stock market
should expect.average returns.
Dispersion around the Mean