The stock market’s historical return can change dramatically depending on the period considered. But over a period of time, on average, the return has been in double digits.
Market is cyclical
Stock market sooner or later reverts back to the mean. If the stock market has rallied up for a particular time-frame, it has also dropped later on significantly to even out the early gain. Before the dotcom bubble burst, the stock market had reached new highs. After the bubble burst, the stock market saw a significant downturn, helping to bring the averages back in line.
You can expect double digit returns in both markets, be it bull market or bear market. However to do that successfully you need to know how to time the market, that is, when to go long and when to short.
Past Performance as a Bad Predictor
The expected return rate from the investment is typically calculated by analysing the past returns, since no one can predict future returns. However, it’s important to realize that those returns may not be replicated in the future. U.S. market saw excessive growth as it grew from a struggling nation into a superpower. That same growth rate cannot be expected anymore, especially with BRIC nations (Brazil, Russia, India and China) knocking at the door.
Buying stocks based on past performance will not ensure the same returns. With globalization and cut-throat competition, if the company is not in sync with current consumer needs, it wont survive, and eventually affecting your returns.
Inflation and Taxes
Inflation and Taxes are the 2 most significant items not accounted for in historical returns. From 1926 – 2004, the average inflation was 3.0%. Short-term capital gains are taxed at ordinary income tax rates of up to 35%, while long-term capital gains and dividend income are taxed at 15%.
Historical returns do not include several items that investors must deal with, especially inflation and taxes. Both factors need to considered to determine what returns to expect.
Individual investors returns
In general, return rate of investors tend to be lower than the overall market. A recent study found that investors in the NYSE and AMEX experienced annual returns that were 1.3% lower than market returns from 1926 to 2002, while Nasdaq investors experienced annual returns that were 5.3% lower from 1973 to 2002.
Pattern of actual returns
Even if you get the average rate of return exactly right, your portfolio’s balance will depend on the pattern of actual returns during that period. Some years will experience higher-than-average returns, while other years will have lower or even negative returns. If you experience high returns in the early years, your portfolio’s value will be lower than if those returns occurred in the later years. If you encounter negative returns in the early years, you will have a higher balance than if those negative returns came in the later years.
What does all this mean to an investor?
When designing an investment program, use a conservative estimated rate of return, since it may be difficult to earn the historical returns of the past.
Few of the important strategies to use for higher returns: