EagleTribune.com, North Andover, MA

September 22, 2013

The illusion of average returns

Financially Speaking
John Spoto

---- — 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.

When the markets react violently as they did during the financial crisis and will inevitably do in the future, unsuspecting investors who have relied on the calming but misleading concept of average returns tend to panic and sprint for the exits when even a well-balanced portfolio experiences a steep decline. There are few faster ways of turning a big pile of money into a little one.

Sensible investors understand that both stocks and bonds deliver variable, not consistent returns. It is both naive and risky to expect to earn an “average” return. Investors should anticipate swings (sharp ones in the stock market) from gains to losses, and only over long investing horizons (decades, not years) should they expect the markets to deliver normalized returns.

Since stocks are more volatile than bonds, and bonds more volatile than cash, it makes sense for investors to begin shifting assets from stocks to bonds and then to cash as they get closer to using the money. This should ensure that the money will be there when they need it.

While no one can predict the direction of the financial markets, building an investment plan that incorporates these simple principles will help minimize the damage to investors’ nest eggs.

John Spoto is the founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com.

This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions.