Investing in stocks is not only helpful in saving money, but also making extra money on your investment. It’s important to know how the market works, and to understand frequently used terms if you want to be successful.
A frequently misinterpreted term is the “average stock market return“. While this term is often used by financial advisers to gain sales and encourage investment, it isn’t always reliable to measure the actual profits or returns. Investing based on this metric alone might have you wondering why your returns are so underwhelming.
It’s often you’ll hear from financial advisers that the average stock market return is about 10%. You’d be surprised to learn this percentage is closer to 6.53%.
Wait, so they’re lying?
Not exactly. If you look at the average stock market return for the S&P 500 since 1900, it amounts to 11.53%. However, this doesn’t mean that if you had stocks for that entire period you would have made 11.53% more than your investment. It doesn’t even mean that annually you would be seeing positive returns. If we take a closer look at how this metric is calculated then things will start to make sense.
Annual Average stock market return calculation
While we won’t go into the more complex ways of calculating the average stock market return, we’ll use the arithmetic mean, or simple average. In order to calculate this metric over a period of time you need to take the percentage of losses or gains each year totaled, then divide it by the number of years to get the average. Don’t worry, we’ll use simple examples for you to follow along.
The calculation will end up looking like this:
Totals Sum of % Gains & losses / Number of years = Average stock market return
Dave invests $500. After 1 year he loses half ($250). The second year he gains $250, so now he’s back at his original investment of $500.
Since Dave’s value decreased in the first year by 50%, it becomes -50%. In the second year it increases by the same exact number ($250) so this percentage is 100%. Using our calculation it becomes:-50% + 100% = 50%. Divide this by 2 years and you end up with an average of 25%.
You can see by this calculation that even though Dave only broke even, the average return is at 25%. Hence, he did not actually make 25% on top of the money he invested as it would seem. At first glance, 25% would sound like a great return on profits.
Dave’s initial investment is $300. The first year his investment drops to $225. The second year it increases to 300$. At the end of the third year Dave’s investment is at $350.
For the first year we get a percentage of -25%. The second year his return increases by approximately 33%. At the end of the third year his investment increases again, but by 16%.
Our calculations should look like this so far: -25% + 33% + 16% / 3 years.
Solving the calculation further gives us 24% / 3 years = 8%.
While we can see 8% is a closer reflection of Dave’s investment returns, it’s still not quite accurate.
There are several other reasons this metric is quite misleading. Since the market is chaotic, especially over short periods, the average stock market return is hardly ever at a constant or dependable rate. If we look at the S&P 500 from 1950 to 2015, the annual returns have only reached the average about 37 times. And 15 of those years have actually resulted in negative returns. Another reason this metric is misleading is that inflation is never accounted for. When adjusting for inflation the average annual return since 1900 doesn’t sit at 10% or 12% but closer to 9%.
A better metric for calculating returns
So is there a more reliable method to calculate returns on my investment? There is and it’s called the Compound Annual Growth Rate, aka CAGR. While there are multiple calculators which find this metric, we’ll briefly touch on how this calculation works. Again, we’ll try to make this as painless as possible.
The formula for CAGR is: ( EV / BV)1 / n – 1.
- EV represents the ending value or your current value.
- BV represents your beginning value or initial investment.
- N is the number of years or months you are calculating for.
If we use the CAGR formula for example 2 it would look like this, step by step.
Since Dave’s initial investment is $300 and ended at $350, (EV/BV) becomes (350/300).
Since this is over a period of three years the exponent 1/n becomes 1/3.
So far our calculation should look like this (350/300)^1/3 – 1.
If we solve it further it now becomes (1.16)^0.33 – 1
One step further (Don’t forget the order of operations), 1.05 – 1 = .05
If we move the decimal place over two places we get a CAGR of 5%.
As you can see the CAGR is a much better metric at gauging the true percentage of returns on your investment. While the annual average stock market return gave us a value of 8%, the CAGR formula provided a more accurate value at 5%.
Average Stock Market Return vs CAGR
If we calculate the annual average stock market return of S&P 500 since 1900, we’ll get a value of about 11.53%. When adjusted for inflation that number is about 8.4%.
If we use the Compound Annual growth Rate formula, from S&P 500 we’ll get a return of 9.7%. If we adjust for inflation that number drops to 6.5%.
Essentially, if you were to have invested money in S&P 500 since 1900, your money would have grown approximately 6.5% annually. Also, if you take into account other fees, then you’ll get a more accurate percentage of your investment return.
As you can see, there are a couple ways to gauge the possible returns on your investment. However, if you want to get an accurate percentage use the CAGR formula.
The next time someone gives you a percentage of the average stock market return, you won’t be fooled. Understanding the market and knowing the true potential on your investments can help you make wise decisions.