“I’ll make 11% per year in the stock market.”
Investing in the stock market can be a gratifying experience for anyone looking to build wealth over time. With that said, it’s essential to understand the difference between expectations and reality before you take the leap. Many inexperienced investors are lured into the market by flashy one-sided statistics, only to abandon their investment plan at the first sight of volatility. Don’t let that happen to you!
Building Wealth: Expectations vs. Reality
Take, for example, the stock market’s average annualized return of 11% over the last 40 years.* After hearing a statistic like this, it’s common for investors to set out on their investment journey with high hopes for quick and easy double-digit returns, compounding 11% per year each year they invest. Two points to consider: 1) past performance is not indicative of future returns, and 2) the average annualized return is just that… an average over a specific period of time.
Still, you might find yourself eagerly doing the math to see how much money you could earn after your first, second, or third year in the market. That’s an excellent way to educate yourself on the power of compounding but it’s crucial to remember what the average consists of… periods of greater returns as well as periods of lower returns or losses. This means that over a period of time, sometimes you’ll make more than the average return, and sometimes you’ll make less or even lose money. Rarely did an investor experience calendar year return even close to the 11% average. That’s how averages work!
Take a look at the chart below showing the returns for each of the last 40 years. You’ll see they range from +37% to -37%, indicating that although we know the stock market has increased over the long run, it’s volatile in the short term and returns vary year-to-year.
Here’s the lesson: Long-term investing is a balancing act between understanding risk and being able to tolerate it. Money that compounded by a steady 11% annually over these 40 years grew to the exact same dollar amount as money that experienced all the real-world ups and downs along the way… it just felt a lot different!
Even though there may be some ‘bumpy roads’ along your journey to financial success, a bit of research and a disciplined approach can put you on the path to building wealth over time. Subscribe to the Beanstox blog for more information on financial markets, personal finance, and investor psychology.
*Source: Beanstox, Bloomberg. Market Returns S&P 500.
** This hypothetical example of compounding assumes the funds stayed invested throughout the investment period. There are risks and limitations in using hypothetical performance in making investment decisions. Performance is provided for illustrative purposes.