Take a look at the following graphic, which is the year-by-year total return performance of the S&P 500 Index from 1987 – 2006:
Now imagine that you had invested $10,000 at the beginning of 1987. NOTE: We are using the returns of the S&P 500 Index itself, which does not include any sort of managment expenses. By the end of 1999, your $10,000 would have grown to $86,108 giving you an annualized return of 18.01%:
The next three years wouldn’t have been as pleasant as you watched your account value drop back down to $53,718 by the end of 2002, a decrease of 38.24% from the peak. OUCH!
It would then take over six years for the portfolio to get back up to the previous peak, which it finally did do sometime during 2006.
So, what’s my point(s) with all this?
1. Things tend to revert back to the mean. Since its creation in 1957*, the S&P 500 index has average around 10%. Although great at the time, returns in excess of 10% should be considered gravy and the investor should expect that over the long run, their rate of return is going to average 10%. The same can be said for down years.
2. After a losing year, it takes a greater rate of return to get you back where you started. In other words, if you lose 25% one year, you need a 33.33% return the next year just to get you back to where you were before. For example:
Say you have a $100,000 and experience a 25% decline, leaving you with $75,000. To get back to $100,000, you need a return of 33.33%:
Another way to look at is during the three declining years (2000 – 2002), the average loss was 14.55%. Over the next 3 years (2003 – 2005), the average gain was 14.39% and yet the portfolio was still worth $5,699 LESS than it was at the end of 1999.
Interesting stuff, don’t you think? It’s amazing what you can learn when you look at the numbers.
*The Index dates back to 1923 but the index as we know it today (containing 500 companies) dates back to 1957.