In steps the Stock Market, promising higher returns than stodgy old bonds, and money market accounts; hence, the stock market became the destination of choice for retirement savings and Wall Street responded by increasing the offerings to retail consumers through Mutual Funds. Before the year 2000 it was not uncommon to hear that the S&P returned 16% over the previous 10 years. Looking at the returns of one of the best known indexed mutual funds, the Vanguard 500, returns since its 1976 inception are 11.75%, impressive until you look at the 1 year return, -2.41%, the 5 year return, 11.89% and the 10 year return 5.06%. These are average returns not real returns. As an example let’s look at the growth of 1 dollar in the mythical High Fly Fund. High Fly posts a 50% gain in one year and your dollar grows to $1.50. The next year it posts a 25% loss, now your investment is worth $1.125. The average return for High Fly reported by the mutual company is 12.5%, but that is not your actual return. Your actual return or compound annual growth rate (CAGR) is in the neighborhood of 6% per year worse if you factor in inflation.

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.

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