As with many other myths, a simple fact led to misinformation.
Do you expect your globally diversified portfolio to produce an average annual return of 10 percent?
Some investors have that expectation — and they become upset when it doesn’t happen. That’s too bad, because the notion that a diversified portfolio will earn returns, on average, of 10 percent per year is a myth — one I’m happy to put to rest.
You’re not crazy if you think you’ve heard about 10 percent returns. Indeed you have heard that figure; it emanates from the performance of the S&P 500 stock index, a widely used market barometer that has, in fact, posted an average return of 10 percent per year since 1926, according to Ibbotson Associates.
But that doesn’t mean you should expect your investment portfolio to generate that return, and here are three reasons.
First, while the S&P 500 has earned an average of 10 percent annually for almost 90 years, that’s only an average. In fact, it has never actually produced that return in any given year. If that’s befuddling, consider that the average U.S. household has 2.3 children — even though no individual household actually has that precise number.
Some have no kids or one, two, three or more, but nobody has exactly 2.3 kids — despite the fact that statistics say this is the average.
Likewise, the S&P 500 has earned 8 percent and 12 percent in a given year. The index has been up 13 percent and down 13 percent during the past 90 years — but in no year did it ever grow exactly the 10 percent it has averaged.
Second, the S&P 500 represents only one specific sector of one specific asset class — the largest companies (that’s the sector) of the U.S. stock market (that’s the asset class). The 10 percent return the S&P 500 has earned on average since 1926 says nothing about any of the other asset classes that exist in the global financial marketplace or any of the many sectors within each of those asset classes.
For example, the portfolios we provide our clients typically feature 18 or 19 asset classes and market sectors. Investments in the asset class of stocks feature exposure to such sectors as large companies, midsized companies and small companies. This asset class also contains the stocks of foreign countries, including both developed nations (those in Europe, for example) and developing nations (including those in South America and Africa).
And that’s just stocks. We haven’t even gotten to bonds, real estate, energy, precious metals, commodities or other financial markets. It’s worth noting that none of these other asset classes and market sectors has produced as high an average annual rate of return since 1926 as the S&P 500.
In other words, unless you’re going to own only the stocks of the S&P 500 in the exact proportion of the index itself, you can’t expect your portfolio to produce the same results as the index.
And third, like all indices, the S&P 500 is merely theoretical. It doesn’t actually exist. As regulators like to point out, you can’t buy an index. Instead, you can buy a mutual fund or an exchange-traded fund that mimics the index’s holdings. Such funds can give you returns comparable to the index — except for the fund’s fees. When you subtract them, guess what?
You’re no longer earning an average of 10 percent per year.
So don’t be annoyed to discover that your portfolio isn’t earning the same return as the S&P 500 stock index. After all, it’s not designed to.
Keep this in mind if some slick salesperson — broker, financial advisor, insurance agent, bank rep or mutual fund marketer — claims that they’ll get you double-digit returns. If you encounter such a sales pitch, walk away.
An index is a portfolio of specific securities (common examples are the S&P, DJIA, NASDAQ), the performance of which is often used as a benchmark in judging the relative performance of certain asset classes. Indexes are unmanaged portfolios and investors cannot invest directly in an index. Past performance does not guarantee future results.