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5 Reasons Past Stock Market Returns Are Totally Irrelevant

by Shawanda Greene

Pumpkin Spice Latte topped with whipped creamPersonal finance enthusiasts – expert and amateur alike – love talking about historical stock market returns. Particularly when they’re trying to convince some poor soul to drop his morning Starbucks.

You know how it goes.

Sacrifice your pricey cup of Joe, and invest the savings in an S&P 500 index fund. Assuming the S&P 500 returns what it has historically, you’ll have tens of thousands of dollars in 40 years.

Although, I’m sure you don’t drink coffee solely for the taste and would replace your Pumpkin Spice Latte with a not-free, albeit cheaper, alternative to satisfy your caffeine addiction.

Either way, the point I wanna make is that historical U.S. stock market returns are irrelevant when it comes to making investment decisions.

And here are five reasons why.

1. You’re not suppose to have 100% of your portfolio allocated to stock.

Dave Ramsey is the only financial expert I know of who advises you remain entirely in the stock market throughout the various stages of your life. As awesome as he is, Ramsey is alone on this one.

Other financial gurus recommend allocating a big chunk of your portfolio to bonds.

Jack Bogle, founder of The Vanguard Group, suggests, as a general rule, a bond allocation equal to your age.

Following that guideline, at the age of 25, you should be 75% in the stock market and 25% in the bond market. At 26, you’re 74% in stocks and 26% in bonds. You see where I’m going.

If your portfolio earns the historical rate of return from the time you start investing until you retire at 67 years old, what is the overall rate of return on your investments?

You don’t know, do you?

Now, why is that?

Because no one pays attention to what the bond market has done historically. Even though many of us are heavily invested in it.

2. You don’t invest exclusively in the United States’ stock market. 

Which is what most people are referring to when they quote past return rates. In all likelihood, you’ll invest in the global economy. Brazil, China, and India all have growing economies with expanding middle classes made up of people who buy stuff . I haven’t given up on Europe. How about Australia? Who knows? Maybe our brothers and sisters in Africa will get it together. What I’m trying to say is that the U.S. isn’t the only game in town.

3. You don’t have the cojones to stay 100% in the stock market.

Even if you followed Ramsey’s advice and allocated 100% of your invested money to the stock market, it’s haaard to leave it in there. It’s especially difficult to keep your cash in an investment that kicks you in the chin from time to time. Let alone continue to believe in it while you’re being abused.

Here’s the thing. The stock market is a real piece of work. An arsehole, if you will. (It’s not cussing if you say it in British.)

One day he’s Tigger high.

The next day he’s Eeyore low.

There are stretches of time when Stock Market is a really sweet guy, giving you 30% annual returns on your investment. Other years, he’s knocking you upside the head with a frying pan, erasing your gains from the previous years plus principal.

Eventually, you get tired of his unpredictable ways. So you kick his crazy butt to the curb. You seek out the warm and safe embrace of Cash. For a while, all is well. But then, people start telling you about all the positive stock news they’ve read about. Suddenly, you’re interested again. After a few drunken, late night text messages, Stock Market pulls you back in.

This time will be different. You know it will because he’s shown you over the last few months that he’s producing great returns again.

Ya go runnin’ back.

You’re the classic buy high, sell low hoe.

Unlike in a human relationship, it’s best you hang in there with the stock market – when he buys you a $40,000 Rolex and when he throws a Lemon Drop Martini in your face.

4. Past performance is not an indicator of future performance. 

If it’s not an indicator, then don’t tell me about it! Shoot!

People are, generally, consistent. If you loaned me money once and I didn’t repay you, I’ll probably stiff you again. Companies’ share prices aren’t like that. In the future, you may get more out of the stock market than historical returns. Perhaps you’ll get less.

Nobody knows.

5. Fees! Glorious, glorious fees!

Since you can’t purchase the S&P 500 index or any broad market index directly, you have to pay someone to do it for you. Even if the U.S. stock market returned 8% in the years ahead, that’s not what you gettin’. After operating expenses, commissions, and such you’ll definitely earn far less. And just so you know, that expense ratio quoted in your fund’s prospectus doesn’t tell the whole story. You’re paying more than that. But we’ll save that discussion for later.

Don’t get me wrong. I’m not saying you shouldn’t invest in stocks. I’m simply highlighting the fact that what’s happened in the U.S. stock market shouldn’t be a factor in how you invest going forward.

Do you agree with me? If not, explain yourself.

 

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{ 1 comment… read it below or add one }

Sinclair89 September 10, 2011 at 5:38 PM

Interesting points you make. Having some part of your portfolio in cash is always a good strategy, but at the same time you have to ask "why" do you keep some cash handy? The answer should be: to take advantage of great opportunities (like the severely undervalued stocks on the market today). Rules are generally nice guidelines, but at the same time you have to be willing to break them every once in a while if it makes sense. Otherwise, you are artificially constraining yourself more than is good for you. The only "rule" I adhere to is that every stock pick must be thoroughly researched and all of the due diligence done, before buying. If there are 5 great value opportunities, there is nothing wrong with investing in all 5 right now, even if it means altering the percentage of cash in your portfolio. Confidence is King and the key to confidence is Queen Knowlege!

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