Your Money_ The Missing Manual - J. D. Roth [126]
Table 12-1. The average annual return for the S&P 500 for these 15 years was 6.07%.
S&P 500 Annual Returns
1995
34.11%
2000
–10.14%
2005
3.00%
1996
22.87%
2001
–12.06%
2006
13.62%
1997
23.74%
2002
–24.66%
2007
4.24%
1998
30.95%
2003
25.28%
2008
–40.97%
1999
19.81%
2004
10.59%
2009
27.76%
Note
The S&P 500 is a stock-market index, which is like a thermometer: It's a single number that gives you a quick reading on the value of a group of stocks. There are all sorts of indexes, including the Dow Jones Industrial Average, the NASDAQ Composite, and the S&P 500. The latter tracks the performance of 500 of the largest U.S. stocks.
As you can see from the table, stocks soared during the late 1990s' bull market, fell during the early 2000s' bear market, and had trouble deciding what to do during the past 5 years. And note that while the S&P 500 index returned an average of 6.07% during the 15 years between 1995 and 2009, not one of those years actually produced returns near the average (2007 came closest, but that was still nearly 2% below the mark).
These fluctuations mess with the average investor's mind: He panics and sells when prices drop, but then falls victim to what Alan Greenspan called "irrational exuberance" (basically, getting way too excited) and buys when prices soar. That's a sure way to lose money. Smart investors understand that average isn't normal, so they brace themselves for fluctuations and try not to buy and sell on impulse. (You'll learn more about smart investor behavior on Being on Your Best Behavior.)
The future is not the past
Overall, the value of the stock market increases with time. But over the short term, market movements are wild and unpredictable. During any given year, the stock market might return anywhere from –50% to +100%. Over long periods of time—think decades—the market is less volatile and its returns are smoother. Looking at 30-year periods, the U.S. stock market is likely to produce growth between 5–15%.
In the short term, other types of investments can and do offer better returns than stocks. During any given 1-year period, stocks will outperform bonds only 60% of the time. But over 10-year periods, that number jumps to 80%. And over 30 years, stocks almost always win: Siegel found that "the last 30-year period in which bonds beat stocks ended in 1861, with the onset of the U.S. Civil War." (For more on this concept, see this article at Get Rich Slowly: http://tinyurl.com/GRS-stock-history.)
There's just one problem: Past performance is no guarantee of future results. This is true both for individual stocks and the market as a whole. Just because the market has had average annual returns of 10% since 1926 doesn't mean it'll do so in the future. (In fact, many smart folks believe returns will be modest over the next few decades.)
Still, if history is any indication, investing in stocks is the best way for you to meet your financial goals. As long as businesses can make a profit—even when they borrow money—stocks will outperform bonds and inflation. All the same, smart investors hedge their bets and manage risk by adding a healthy dose of other types of assets, especially bonds.
But what exactly are stocks and bonds, anyhow? Let's take a brief detour to learn about the tools of investing.
Note
Risk and return are inseparable. If you want high returns, you have to accept that you'll sometimes suffer big losses, which may affect your future plans. If you're risk averse—not willing to risk losing money—you can find "safe" investments, but they'll offer low returns so it'll be more difficult to meet your goals.
The Tools of Investing
Assuming you're an average individual investor, you've got two primary tools at your disposal: stocks and bonds. (Other asset classes include real estate and commodities like gold and oil—but investing in these