The Average vs The Actual Return of the Stock Market

The average return of the stock market is around 10% per year over extended periods of time depending on how you measure it. For example, the S&P 500 is an index that tracks the performance of the 500 leading companies in the US across eleven sectors.

It is often used as a measuring stick for how the stock market is doing as a whole. The index was introduced in 1957 and has provided an average return of around 10% per year. Average returns are calculated by adding up annual investment returns and dividing them by the time period.

For example, let's assume that the S&P 500 produced the following returns over the past 5 years. (This is not real data and should only be viewed as an example.)

Year 1 - Positive return of 15%.

Year 2 - Positive return of 18%.

Year 3 - Negative return of 9%.

Year 4 - Positive return of 16%.

Year 5 - Positive return of 10%.

The average return during this 5 year period is 10% per year. Many investors make the mistake of basing their return that their investments will provide on the historical average rate of return. This is not a good idea as the average returns that your investments provide are not always the actual return.

The actual return that you experience from investing in the stock market is your true return. Let's look at an example to prove this. Say that you put $5,000 into a stock portfolio. In year 1 the portfolio went up  20%. In year 2 the portfolio went up another 25%. In year 3 the portfolio went down 15%.

This would leave you with an average return of 10% over those three years (20% + 25% -15%)/(3). However, you need to take a closer look at what happened to see your actual rate of return.

1) Year 1 - In year 1 your initial $5,000 grew by 20% which would leave you with a balance of $6,000.

2) Year 2 - In year 2 your $6,000 balance grow by another 25% which would leave you with a balance of $7,500.

3) Year 3 - In year three your $7,500 balance went down by 15% would leave you with a balance of $6,375.

The total amount of money your account earned over the three year period is $1,375. Your actual return over the three year period is just over 7.6% ($1,375/3)/($6,000). This is a 2.4% difference when compared to the average return.

If you assume that your money is growing at the average rate of return, you will end up with less money than anticipated. Let's look at another example to prove this. Assume that you have $10,000 to invest. To keep things simple, we are going to look at a hypothetical scenario over a 5 year period.

1) Year 1 - In year 1 your balance goes up 20%.

2) Year 2 - In year 2 your balance goes up another 9%.

3) Year 3 - In year 3 your balance goes down 18%.

4) Year 4 - In year 4 your balance goes up 9%.

5) Year 5 - In year 5 your balance goes up another 15%.  
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Your average return on your initial investment of $10,000 during this time is 7%. If you were to purely apply this average return of 7% to your account during this time, you would have $14,025 as indicated by the chart below.

However, your actual rate of return is lower than the average return of 7%. Let's look to see what actually happened with your money.

1) Year 1 - In year 1 your initial $10,000 grew by 20% which would leave you with a balance of $12,000.

2) Year 2 - In year 2 your $12,000 balance grow by another 9% which would leave you with a balance of $13,080.

3) Year 3 - In year 3 your $13,080 balance went down by 18% would leave you with a balance of $10,726.  

4) Year 4 - In year 4 your $10,726 balance grew by 9 which would leave you with an account balance of $11,691.

5) Year 5 - In year 5 your $11,691 balance grew another 15% which would leave you with an account balance of $13,445

This would make your actual rate of return just over 6.8%. This seems like a trivial difference, but results in a difference of $580 when compared to the average rate of return of 7%. Over time, this discrepancy would only grow larger given the same conditions.

The difference between the average rate of return and the actual rate of return can be the difference between achieving your financial goals or not achieving them. Let's look at another example to prove this. Say that your main investing goal is to save for your retirement.

You plan to hold stock investment funds through a Roth IRA and your employer's 401k plan. You plan to invest $7,000 per year into the Roth IRA, and $10,000 through your 401k which includes your employer's matching contribution. This would be a total monthly contribution of $1,416.66.

You assume that you can earn an average annual return of 10% on you investments and plan to invest over a 30 year period. If we apply the assumed average rate of return of 10% per year, you would have just under $2.8 million when you retire as indicated by the chart below.

$2.8 million sounds great, but let's assume that your actual return during this 30 year period is 8.75% as opposed to the average return of 10% per year. Let's do the calculation again with the actual rate of return of 8.75% and keep the other variables the same. An actual rate of return will leave you with just over $2.2 million when you retire as indicated by the chart below.  

The difference between the average rate of return of 10% and actual rate of return of 8.75% seems like a trivial 1.25% difference. However, it produced a $600,000 difference. If you were making your retirement plan based upon the average rate of return, you would have $600,000 less than expected if the actual return were 8.75%.

It is hard to base your future investment values on the actual rate of return as you do not know what the actual rate of return will be in the future. However, it is better to plan for a lower actual return than a higher average return.

For example, let's say that you are looking at investing in a mix of index funds that have an average return of 10% per year over long periods of time. As you plan to invest, you could assume that the actual return is going to be around 8% per year.

By doing this, you win no matter what happens. If the actual return ends up being 8%, you will not be disappointed as you already planned for this. On the flipside, if the funds really do provide an actual return of 10%, you will be pleasantly surprised with a higher return than expected.

To get a completely accurate gauge of what the actual return of an investment would be, you can do the calculations. Look at the historical return of the investment over an extended period of time, such as 20 years. Take a hypothetical investment amount, such as $100, and manually calculate what each return did to the $100 each year.

For example, let's say that an index fund that you were looking at investing in had produced these returns during it's initial 5 year period.

Year 1 - 10% positive return which would give you $110.

Year 2 - 12% positive return which would give you $123.20.

Year 3 - 9% negative return which would give you $112.12.

Year 4 - 15% postive return which would give you $128.8.

Year 5 - 5% positive return which would give you $135.24.

If the index fund had a 20 year history, you would want to continue doing this calculations for all 20 years based upon the returns per year. For sake of example, let's say that at the end of the 20 year period, the original $100 is now worth $270 after calculating the return for each year.

To find the actual return subtract the initial investment from the final amount ($270 - $100). This would leave you with $170. You then want to take this amount and divide it by the total amount of years, which is 20 in this case.

This leaves you with $8.50 return per year. To convert this to a percentage, you need to divide it by the original investment amount of $100 and then multiply it by 100. This would give you an actual return of 8.5% per year ($8.50/$100) x (100).

Manually calculating the actual returns for your investments is a cumbersome process. However, as emphasized throughout this article, the difference between the average return that your investments provide and the actual return can be the difference between reaching or missing your financial goals, so it can be worthwhile.  

If you do not want to manually calculate the actual returns of your desired investments, you can consider working with a financial advisor. A competent financial advisor should be able to explain the difference between the average rate of return and the actual rate of return.

If you plan to work with a financial advisor, ask them to explain what return you can expect on your investments. If the advisor starts to tout an impressive average return of a particular investment without explaining the actual return, it is a red flag.

The bottom line is that the actual return of the stock market often differs from the average return of the stock market. It is more important to base your investment assumptions on the actual return as the actual return is what your money uses to compound and grow.

Many wealth management firms and brokers boast about the average return that their stock investments provide. However, be wary to base your future investment values on average returns alone as you might end up with less money than anticipated.