How often do you look at your returns? Whether you have money in a 401(k) or invest on your own, it can be a confusing game indeed to find out just how much your money is growing—or not.
And investors have been on a roller coaster ride ever since the financial crisis.
Consider that the Standard & Poor's 500-stock index—the bellwether benchmark that tracks the 500 largest stocks in the U.S.—plunged 37% in 2008, had double-digit gains of 26% and 15% in 2009 and 2010, respectively, and then, in 2011, went almost flat at 2.1%.
Last year, it surged again by 16%. So far this year, it's up 15%.
What Does the Rise and Fall Mean For Me?
These erratic zig-zags can make you wonder what a reasonable expectation is when it comes to your stock market returns. And that's important to know because what you expect to earn from stocks will determine how you build your portfolio. If your predictions are too rosy, you won't have enough saved for retirement. If your forecasts are too grim, you'll make unnecessary sacrifices to your lifestyle today.
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The experts in the investing community are divided on what will happen from here on out. Some believe volatile stock market returns since the financial crisis will revert to long-term averages. Others think we've entered an extended period of lower returns on assets because of the debt loads and aging populations of developed countries. Mohamed El-Erian, CEO and co-CIO of PIMCO, the company that runs the world's biggest bond fund, popularized the term "New Normal" to describe this potentially bleak future for investors.
The "New Normal" or Just Normal?
One way to make an educated guess about the future is to look to the past. Obviously, past performance doesn't guarantee future results. But knowing the average returns of stocks over long periods can help you figure out if you have the right expectations for your portfolio.
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Fortunately, Ibbotson, an investment research division of Morningstar, has performance records for different types of stocks going back to 1926. Stocks of large companies—such as General Electric, IBM and Microsoft—have returned an average of 10% per year from 1926 to 2012. Stocks of small companies did slightly better with an average annual return of 12% from 1926 to 2012.
Financial analysts say small-company stocks (stocks with a market value between $300 million and $2 billion) tend to return more than the large-company stocks over time because they can have more investment risk and typically have higher growth rates.
Based on those figures, you could assume a stock portfolio could expect an average 10% annual return over a 20- to 30-year period of saving for retirement. But that estimate may be too optimistic.
Ibbotson forecasts that stocks will produce an average 7.8% annual return over the next 20 years for the same reasons El-Erian and other New Normalers expect the future to be less prosperous.
The Power of 1%
The difference between a 7.8% average annual return like Ibbotson's and a 10% average annual return based on historic returns may seem insignificant, but it makes a huge difference over time. If you invested $10,000 for 30 years at 10%, you would have $174,494. And if you invested $10,000 for 30 years at 7.8%, you would have $95,184.
But even an expectation of 7.8% annual returns for stocks may be too upbeat. “Things are going to be different for a while,” says investment strategist Rick Ferri at Portfolio Solutions in Troy, Mich.
He forecasts that large-company stocks will return an average of 7% over 30 years (a $10,000 portfolio at 7% would be worth $76,123 in 30 years) and small-company stocks will gain 8% over the same period (a $10,000 portfolio at 8% would be worth $100,627 in 30 years).
To add insult to injury, none of these forecasted rates from Ibbotson or Ferri include investment fees, taxes and inflation, which will reduce returns further.
What You Can Do
Don't despair. Realize that these rates of returns are forecasts. No one can accurately predict the future, especially 30 years from now. Nevertheless, here are some things you can do to improve your odds whatever the market holds:
Start Early: Let's say you want to retire at 65 with $1 million in savings. Assuming an average 7% market return, if you start at 25, you have to save $5,009 a year (or $417 a month) to reach your goal. If you start when you're 35, you have to save $10,586 a year (or $882 a month). At 45, it's $24,393 a year ($2,033 a month). You get the picture.
Mind the Fees: High investment costs can eat into your nest egg. An analysis by the Vanguard Group, a mutual fund company, bears this out. It found that if you invest in a fund with a .90% annual fee—the expense ratio for the average U.S. stock fund—you'd lose $94,000 more in fees, based on a $100,000 portfolio that grew 6% a year over 30 years, than an investment in a fund with a .25% expense ratio. Index funds, designed to track at market benchmark like the S&P 500, tend to have lower costs than funds that are run by a manager, known as actively managed funds.
Max Out Your 401(k): Of course, that's easier said than done, and if you're not doing it, you're certainly not alone. Last year, only 11% of the more than 3 million participants enrolled in retirement plans administered by Vanguard saved the maximum allowed, according to the firm's "How America Saves 2013" study. “You think if your [company] is enrolling you automatically, that’s great, but it’s not enough,” says Jean Young, the study's co-author. Can't get all the way to the max? Don't worry. LearnVest planners recommend trying to up your contribution by 1% every six months until you reach the limit.
Remember, you're investing for the long haul. Taking these steps will help you build your retirement savings on a strong foundation regardless of what the market does.
Information shown is for illustrative purposes only and is not intended as investment advice. Please consult a financial advisor for advice specific to your financial situation.