Expected Returns

Quick: what return should a stock market investor expect?  If you own an IRA or 401K, you probably invest in stocks through mutual funds.  We do this so that our money has a chance to "work for us" and grow into a larger sum in the future.  Investing in bonds or CD's, we earn a stated rate of interest.  This is relatively low risk and low paying.  Stocks, however, are sexy.  In contrast to bonds, there is an expectation of high returns.  The higher the returns, the more our money compounds and we end up with a much larger nest egg.
 
But what rate of return should we expect from our stock investments?  When you fiddle with one of the many online retirement calculators, you usually have to enter an expected rate of return, so what do you use?  Wait, didn't that fund manager on CNBC claim 16% average returns?  Didn't that stock broker quote a statistic in the 13% range?If you guessed or knew the answer to be ten percent, you would be correct.  All other numbers are arrived at by using smaller sets of data.  For example, if you use just the last 30 years, the average annual return is 13% which includes the greatest extended bull market in history.  In fact, since 1926 (earliest date of reliable data), the market (as defined by the S&P 500 index) has returned on average 10.2% per year.  As was often heard on SNL, "Isn't that convenient!?"

Interestingly, the S&P 500 index represents the largest companies in the US stock market and for that matter in the US economy.  The companies in the index take in over $8.5 trillion in annual revenues compared with the whole US GDP of about $13.8 trillion.  In other words, the S&P 500 follows the performance of over 60% of the economy.
 
When you hear the economy grew something% last quarter, the number is usually in the low single digits.  In fact, the US economy grows on average about 3% annually.  Huh?  If the economy grows 3%, how can the stocks representing the economy grow 10%?
 
Well, not all is as it seems.  First, the 3% growth in the economy is sans inflation or "real" growth.  Inflation has also averaged about 3% since 1926 and "nominal" GDP does in fact grow at something near 6%.  Over time, inflation is largely irrelevant to the stock market.  This is because if a company's costs rise, it must eventually increase prices as well.  These don't always rise in perfect tandem, but over time the two pressures must equalize.  From the perspective of a long-term investor, inflation passes through the system.  Thus, 3% real growth becomes 6% nominal growth.

The seemingly missing component is that of dividends.  Dividends are a portion of profit returned to shareholders each year and thus provide current income.  We can say that earnings growth compounds and thus keeps pace with economic growth while each annual dividend adds to the compounding return.  Not surprisingly, dividends have averaged over 4% since 1926 bringing out total return to just over 10%.
  
In essence, investing in stocks with a long-term (decades long) perspective allows one to have their capital help fund and participate in the country's economic growth while earning a premium for accepting the risk.  (*This is NOT investment advice; Past performance is no guarantee of future results.)