The above graph plots the history of a $1 investment in 1871. The bottom curve (blue) shows the price history of index, while the top curve (red) shows the price history of an investment with dividends reinvested. The index itself tracks inflation closely (the index has an average return rate of 3.91%/year  not much higher than the 3.26%/year that the CPI data gives). The investment with dividends reinvested has an average annual return rate of 8.61%/year. To calculate these rates, I took the ratio of the value of the investment at one year to the value from the previous year. I then took a geometric mean of these values to come up with the average return rate.
The below graph is somewhat more interesting because it has been CPIadjusted. All values are given in 2009 dollars.
Once again, the top curve (red) shows the investment history with dividends reinvested, while the bottom curve (blue) is an inflationadjusted price history of the index. In this case the index has an average return rate of 1.80%/year, while the dividendsreinvested investment has a return rate of 6.41%/year. The following histogram shows the spread in returns for the inflationadjusted, dividendsreinvested case:
If history repeats itself, a longterm investor can expect to earn an inflationadjusted 6.41%/year in the S&P 500. After a 15% capitalgains tax, the investor will be left with a 5.45%/year investment (some fraction of which will be lost to a financial adviser/firm). At 5.45%/year, the investment should double in just under 13 years (the doubling time is given by 100%*ln(2)/investment rate). This 5.45%/year is significantly less than the 10%/year I seem to remember mutual fund advisers quoting. This leads me to believe that the real way to get rich (other than, you know, earning money) is to maximize your personal savings rate (the American average being 6.98%/year).
Copyright © 2010 Peter Dolph





2 comments:
You need to account for risk in order to see how mutual funds can offer a 10% return. The S&P500 is a (somewhat narrow) market tracking investment index, and so will have close to the minimum risk level (variance of returns) that is possible in the marketplace. It is very much possible to yield a 10% return in the market using a mutual fund, but the underlying risk on that fund must necessarily be higher than the S&P500. In the end, it is a question of investor risk preference  if you like risk, you can (potentially) earn a higher reward (while accepting that you may also "earn" higher losses); otherwise, there are plenty of lowrisk (corporate bonds) or riskfree (US TBills) investments out there that earn small returns.
Inflation affects all investments denominated in the same currency. So when you're deciding how to invest your money, inflation only matters if you're picking a currency. So the afterinflation return might be 4%, but the afterinflation return of a savings account is 0%.
It is a good thing to remember, though, when planning for retirement. Your return might be 10%/annum (stock market has done slightly better in the past 50 years than in 18701920 I think), prices will go up by 4%/annum, giving you a real return of 6%. So you need to save enough to compensate.
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