Certainly you can get much better returns from stocks and mutual funds than you can from bank accounts. Over long periods of time stocks have averaged 12-15%, compared to 6-10% for bonds and maybe 1-3% for bank assets like CDs and money market funds. The reason is that you are taking a bigger risk by investing in stocks than you are in the bank, so stocks are priced so that when things do work out you make enough to justify the risk that you took. After all, if I asked you to loan me a thousand and you knew that there was a 10% chance I would not pay you back at all, and maybe a 35% chance that I would just pay you back the $1000 after a few years without any interest, you wouldn’t loan the money to me unless you knew there was a chance I might pay you back $1500 in a year or two. That way, if you had enough people like me and you made enough loans, you could be assured of making enough from the ones who paid you the $1500 to make up for the few that just kept your $1000. You’d need to make enough from those who did pay you interest to counterbalance even for the cases where you just get your money back and no interest, since otherwise you’d be better off just putting your money in the bank and earning 2% than to loan to those people and get no return. The trouble is, you don’t know who is who at the start.
And that’s something you really need to understand when looking at returns from stocks and even bonds. The returns stated aren’t regular, consistent, or predictable. In any given year, stocks may be way up or way down. You can’t plug 12% into a compound interest calculator and predict what your account balance will be in 1, 3, or 5 years. To see this, look at the table below that gives the annual returns for the Vanguard Small-Cap and Mid-Cap Index Fund ETF Shares (taken from the Vanguard Prospectus) for the period from 2005 through 2013:
A graph of these total return numbers are shown at the start of this post.
Presented below are the values of an initial investment in the Small-Cap and Mid-Cap index of $10,000 in 2004, the total return for the full, 9-year period, and the annualized return for that 9-year period.
|Value of $10,000 Invested in 2004|
Note that over the 9-year period there were some very good years and some very bad years. If you had invested in 2004, but then needed the money in 2008 and sold the shares of your fund to raise the cash, you would have actually lost a couple of thousand dollars. You would have done even worse if you had invested in 2007, losing 40% of your investment over the next year. On the other hand, if you had invested after the drop in 2008, you would have done spectacularly well, increasing your portfolio value by more than 150 % in the next five years.
In total, you made an annualized rate of 9.32% in the Small-Cap fund and 9% even in the Mid-Cap fund, meaning that you would have ended up with the same amount of money at the end of the period investing in these index funds as you would have received if you had put the money in a fixed income security paying a straight rate of 9.32% and 9% per year, respectively. The way you earned that return, however, was very unpredictable and truly a wild ride. This period of time, with the housing bubble burst causing a large decline in stocks in 2008 was certainly more volatile than normal, but there will always be times like this if you invest for a long period of time.
Note also that you would have come nowhere close to 9% if you had timed the market wrong and been on the sidelines during critical periods. For example, if you had gotten distraught after the collapse in 2008 and sold out, you would have missed out on a 36-40% increase in 2009. If you had thought that the market moved up too quickly in 2009 and sold out, expecting a pullback in 2010, you would have missed out on a 25% return. Either one of these moves would have reduced your annualized return drastically.
So the real answer to the question about what kind of return you can get from stocks and stock mutual funds is that you can get between 12% and 15% over long periods of time. This will come with some spectacular years where you earn 40% or more, and some bad years where you’ll lose 40% or more. You won’t know during any one-year, or even three-year or five-year period what kind of return you’ll get or even if you’ll get a positive return. This is why you should not invest money you’ll need in a short period of time unless you can afford to lose a portion of that money. For example, if you have $100,000 but really only need $30,000 in three years, you might be willing to invest it and take the risk of losing $50,000 for the chance of making $50,000 over that period. If you really needed the full $100,000, however, you would be much better off just putting the money in a bank CD where you would know it would be there in three years rather than hoping that things would work out.
If you don’t need the money for 10 or 20 years, however, you really should invest the money in equities since the returns you will get will be far better than you will see in bank CDs or even bonds. You can also then start to use a financial calculator, plug in an annualized return of 12% or 15%, and get an idea of what you account will be worth in 10 or 20 years. You just don’t know what the value of the account will be in any given year within that period.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.