As they say, you can drown in a river that has an average depth of 6 inches (should you attempt to cross and find that, at this particular point, the river is 8 feet deep).
Similarly, investors must be cautious about data regarding average returns offered by investments.
For example, if an investor were to look look at calendar years from 1928-2008, he would see that the stock market has earned an (arithmetic) average after-inflation return of 7.9%. Not bad! But to count on earning an 8% real return is to set oneself up for failure. For example:
- In 28 of those 81 years, the stock market actually lost money.
- In 8 different years, the market lost more than 20% of its value.
- In 4 different years, the market lost more than 1/3 of its value (with the worst year being 2008, with a loss of 36.6%).*
And, as investors were reminded in the last year, even lengthier periods can be subject to wildly variable rates of return. Again, looking at calendar years from 1928-2008, we can see that:
- In 10 of the 72 ten-year periods, the market lost money.
- Over the 10-year period ending in 1974, a stock market investor would have lost more than 37% of his money, with a compounded real rate of return of -4.6%.
Takeaway Lesson: When making an investment plan, be sure to take into account not only average returns, but the variability of returns as well.
*I only noticed while writing this that on an after-inflation basis, 2008 (real return of -36.6%) was in fact worse than 1931 (real return of -33.8% due to annual deflation of approximately 10%).