stock market charts

Is 6 % acceptable given the risk that investors take on by investing in the stock market? David F. Swenson, CIO of the Yale Endowment explains investor risk in his book, Unconventional Success, when he states: “Because equity owners get paid after corporations satisfy all other claimants, equity ownership represents a residual interest. As such stockholders occupy a riskier position than, say, corporate lenders who enjoy a superior position in a company’s capital structure. ” He goes on to say “the 5. 0 percentage point difference between stock and bond returns represents the historical risk premium, defined as the return to equity holders for accepting risk above the level inherent in bond investments. ” Mr. Swenson’s comments and calculations of the risk premium were based on a compound annual return of 10. 4 % in the stock market compared with 5 % bond yields. 10. 4 % - 5 % equals a risk premium of 5. 4 %. Unfortunately I have yet to find a calculation of CAGR ( compound annual growth rate ) that matches Mr. Swenson’s. I found many examples of average returns that match the 10. 4 % average growth rate but not the CAGR. The reason that this is important is that all other savings vehicles are quoted by the CAGR. Your savings accounts, bonds and money market account are all quoted by the CAGR or its equivalent, the annual percentage yield ( APY ). In order to determine where to allocate your funds, you must compare apples to apples not apples to oranges. As you might guess the CAGR for the stock market is lower.

A quick look at the CAGR calculator for the stock market on moneychimp. com shows the average return from January 1, 1975 to December 31, 2007 to be 9. 71 %. You only realized that return if you were invested in the market the entire time. What if you began investing in 1980? The numbers look about the same. If you started in 1985 your returns look a little better. By 1990 the CAGR drops to 8. 21 %. If you started in 1995 your CAGR jumps to 9. 32 %. If you began investing in 2000 your CAGR drops to minus 0. 06 %! If you eliminate the results of the past 7 years from the S&P performance and track performance from January 1, 1975 to December 31, 1999 the CAGR was 13. 03 %. When the stock market is good it is great, when it is bad, it is pretty darn miserable. For the record, there has been only one 9 year period from January 1, 1950 to December 31, 2007 in which the average return for the S&P was 16. 14 % and the CAGR was 15. 32 %: the period from January 1, 1990 thru December 31, 1999.

It should be clear from these numbers that your returns are dependent not only on how long you are invested in the markets but when you started investing. In fact the stodgy old bond investor has outperformed the stock investor over the past 7 years.

The 1990’s investor will have a very different view of market performance than the 2000’s investor.