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Business

September 22, 2013

The illusion of average returns

In order to make smart financial decisions, including how to invest and how much to spend today and save for tomorrow, investors need to develop average long-run return projections for stocks and bonds.

Ironically it is the misinterpretation and misapplication of the term “average” that has caused substantial damage to the nest eggs of American workers and retirees.

“Average” returns of 10 percent for stocks and 5 percent for bonds were cited so frequently and with such conviction by those in financial circles that the investing public accepted the notion that they could count on these returns. Unfortunately, those who did so without fully understanding its implications, were left feeling stunned and betrayed after experiencing one heart-stopping market decline after another in 2008 and 2009.

Depending upon your stage in life (e.g. working and saving or retired and spending), there are multiple dangers with relying on long-term averages when making financial decisions.

First of all, these historical returns are not returns investors can expect to earn because they do not account for investment expenses and taxes, the combined impact of which can easily skim 40 percent off the top.

The greatest risk, however, is the sense of complacency that can lull an investor into believing the financial market will deliver returns with greater consistency than is possible. The reality is that the years in which either the stock or bond markets have delivered anything close to their historical average returns have been rare.

Financial markets, especially stocks, are unpredictable and highly variable from year to year and even over periods of a decade or more. In other words, the financial markets behave like a pendulum, spending most of the time at or near the extremes delivering big gains and big losses and very little time in the middle earning average returns.

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