Your actual return is based on several variables. The annual stock market return has generally been around 10% since 1926. Because of this, it has been used as a benchmark when determining performance goals for long-term equity investments. In financial planning, benchmarks and general rules of thumb can be useful because they indicate whether you are on the right track. They help make quick estimates and approximations, but they might not always take important variables into account. Several variables, such as your risk tolerance, time horizon, and more, will determine whether the 10 percent rule of thumb is a good benchmark for your portfolio.
Main Points
- For almost a century, the stock market has produced returns of 10% on average per year.
- This average can be used to project future savings amounts as well as how much should be invested in stocks to achieve long-term financial objectives.
- The benchmark is merely a place to start. You must also take into account other elements, such as the investments you are making, your risk tolerance, the length of time you plan to keep your investments, inflation, and taxes.
- Future success cannot be predicted based on past performance.
What Is the Rule of Thumb Average Stock Market Returns?
Over nearly a century, the stock market has generated returns of 10% on average. As a result, investors frequently use this as a general rule of thumb to calculate how much their investments may be worth in the future or how much money they need to set aside in order to achieve a financial goal.Where Did This Rule of Thumb Originate From?
The ten percent rule of thumb is based on the stock market's historical average annual return, which is typically determined by the performance of the S&P 500 index. The health of the market as a whole is reflected in this index, which monitors the performance of 500 of the biggest companies in the United States across 11 sectors. The Standard and Poor's 90 indexes were used before the S&P 500 was released because it wasn't until 1957.How to Apply the Typical Stock Market Return
The 10 percent rule incorporates many years when the stock market returned less than 10% because it is based on decades' worth of data (as well as many when it returned more). Therefore, it should only be utilized for long-term planning objectives like retirement or child tuition savings. It allows you to make projections regarding potential initial and ongoing investments as well as the amount of money you will need to set aside each year in order to reach your goal. You can figure out how much you need to invest in stocks, for instance, if your objective is to have $1 million available for retirement in 30 years. Use this general guideline to estimate your average annual return. In this instance, an investment of $507 per month at a 10 percent annual rate of return would be necessary. It's interesting to note that if you had started doing that ten years earlier, you could have reached your objective by saving just $189 per month ($2,268 annually). This not only demonstrates the usefulness of the 10 percent rule but also emphasizes the necessity of beginning to save early in order to benefit from compound interest. But a number of things could influence your return. Your investment decision, which your time horizon and risk tolerance influence, is perhaps the most crucial. Inflation will lower your purchasing power and consequently lower your effective return, while management fees, expenses, and taxes will also have an impact on your average return.Time Period
If you're preparing for a retirement that will occur in 20 to 30 years, the 10 percent average annual stock market return is a good place to start because it is based on decades of data. But it also takes into account the market performance of an equity-only portfolio. In other words, having a portfolio that is entirely comprised of stocks will increase your chances of achieving the same return. However, if your time frame is much shorter—for example, if you plan to retire in the next five years—you should revise your expectations (and your portfolio's asset allocation). This is due to the rarity with which short-term stock market returns coincide with long-term averages. For instance, the financial crisis caused the S&P 500 to decline by 39% in 2008. It increased by 30% the following year. In fact, your portfolio would have lost 2.26 percent annually if you had invested in the S&P 500 for five years, starting in 2004 and ending in 2008. (each year). You would have only gained an average of 0.55 percent annually if you had been in for the five years ending in 2009. The 10 percent benchmark should not be applied to shorter-term, more urgent financial goals like saving for a car or vacation. For shorter time horizons, the 10% rule of thumb is inapplicable because of this. In order to ensure that your investments will be there for you when you need them, it is best to choose less volatile (less prone to large market swings) and more conservative investments. Unfortunately, this usually results in lower long-term returns. The following is an illustration from Drew Kavanaugh, a CFP and vice president of the wealth management company Odyssey Group Wealth: When saving for college, he explained, new parents can assume more risk at a younger age for their kids. But as the tuition bill approaches, they want to ensure that their savings are less vulnerable to wild market swings.Acceptance of risk
Your risk tolerance, or how well you can handle big gains and losses, impacts your portfolio's asset allocation, just as it does on how long you'll be investing. This is due to the fact that achieving long-term gains requires sticking with the market over a long period, regardless of the ups and downs; in other words, it necessitates refraining from overreacting by selling when you're losing money and then attempting to predict when to buy back in. It's important to note that in this situation, "buy and hold" does not preclude you from making necessary portfolio reallocations. Instead, it means that you continue to invest despite market ups and downs. Your ability to withstand large market swings and repress the urge to sell will be influenced by how much risk you can tolerate. A more conservative portfolio allocation, on the other hand, makes more sense if you have a lower risk tolerance and fear major losses to the point where they might keep you awake at night or drive you to sell your holdings. This means that your portfolio should be safer and not exposed to significant losses (or gains). Fixed-income investments, such as bonds and bonds, CDs, and money market funds, can be added to your portfolio to achieve this. However, if you include fixed-income investments in your portfolio, you must lower your expectations for expected returns. A "balanced" portfolio, for instance, would consist of 50% stocks and 50% fixed income and have an average annual return of 8.3% since 1926.Taxes
The value of your return may be diminished by taxes depending on your account type and how long you hold individual investments. Short-term capital gains are gains from investments held for less than a year that are subject to ordinary income tax rates if you have a taxable brokerage account. However, if you hold investments for more than a year, you'll pay a lower long-term capital gains tax rate—between 0 percent and 20 percent, depending on your tax bracket—when you sell. As an illustration, let's say you earned $100 from selling a stock you purchased for $1,000 and held for less than a year. If your tax rate is 22%, you could pay $22 on the short-term gain, bringing your net gain down to $78 and your net return on that stock down from 10% to 7.8% for the year. If the gain were long-term (you sold after a year), you would have to pay $15 in taxes if your long-term capital gains rate is 15%, bringing your net return down to 8.5 percent. In light of this, it is recommended to use tax-advantaged accounts, such as IRAs and workplace retirement plans like 401(k), when saving for a long-term objective, such as retirement. Gains in these accounts are not taxed, enabling gains to compound and experience "tax-free" returns that are more closely comparable to the standard return of 10%. Although earnings in traditional IRAs and 401(k) accounts are not taxed, withdrawals will be subject to ordinary income tax. While you can contribute to a Roth account using after-tax money, it does not tax qualified withdrawals.Fees
In the same way that taxes reduce your return, if you pay someone to manage your portfolio, those fees also do so. Management fees can vary depending on the services you require and the company you hire. However, even if you manage your portfolio, you are likely paying mutual fund expense ratios, which are fees paid to mutual funds for distribution, marketing, and fund management. The typical expense ratio for mutual funds in 2019 was 0.45%. Let's take a $10,000 mutual fund investment in a tax-advantaged retirement account as an example to show you how even small fees can reduce your expected return. We'll assume that the expense ratio for the fund is 0.45% and that your typical annual market return is 10%. The investment would increase to $154,302 after 30 years. The same investment would be worth $169,797 after 30 years, which is $15,495 more if the fund had, for example, an expense ratio of 0.10 percent. A word of caution: Just because an advisor charges more money doesn't guarantee you'll receive better service. Before choosing a working advisor, do some research.A Salt Grain
Your results might not match the benchmark return of 10% even if you hold investments with extremely low fees for at least ten years and invest entirely in stocks. Why? There are various causes.The Returns on Different Market Sectors and Stocks Vary
The S&P 500 Consumer Discretionary Index, for instance, has a 10-year average annualized return of 17.02 percent, while the S&P 500 Energy Index has a 10-year average annualized return of -1.67 percent. Your return is impacted by market timing. The timing of your entry into a stock or fund and the length of your investment determines your return. Let's take the hypothetical case of an aggressive investor with a high-risk tolerance. You choose to place your money in a fund that follows the MSCI Emerging Markets Index, which consists of 27 large and midcap companies from 27 "emerging market" nations. You would have received an average annual return of 12.35 percent through 2020 if the fund you are in mirrors it and you invested in it in 2009. (not accounting for management fees). But let's say you were admitted two years later, in 2011. Then, at 5.07 percent, your average annual return would have been less than half as high.The Value of Your Return Is Eaten Away by Inflation
Your income's purchasing power will be impacted by inflation. The number of goods and services that one dollar can typically buy decreases over time. The real rate of return, for instance, is 7 percent when you adjust a 10 percent stock market return for a 3 percent inflation rate.Uncertainty Might Influence Investment Decisions to Be More Conservative
Additionally, it's crucial to remember the proverb that past success does not guarantee future success. As a result, financial advisors might make more cautious assumptions when planning. According to Kavanaugh, "it could significantly affect the client's life if we overestimate market returns and underestimate living expense or inflation." I don't want to be the one to inform a client that they will need to find employment after retirement because our projections were too optimistic. The cautious approach might call for larger contributions, but it can avoid shortfalls if the market doesn't perform as well as in the past.