Wall Street’s Double or Nothing

The odds of Leicester City Football Club winning the Premier League were 5,000 to one. If you had bet your entire retirement on Leicester, your retirement date just moved up by about 50 years.

The S&P 500 Index is now officially in the second-longest bull market run in history. That sounds great … until you remember that it was immediately preceded in 2008 by the second-worst financial catastrophe in history. In less than a year, the S&P 500 lost half its total market capitalization, roughly $7 trillion.

Over the past seven years, from the 2009 bottom to recent levels, the index roughly tripled. But if you had long-term investments eight years ago and rode the roller coaster down and back up again, your compound annual rate from 2007 until now drops to less than four percent.

Although the S&P looks like a sure first-place winner, the odds are that this horse may be running out of steam. When rebalancing your portfolio, it’s important to understand the difference between compound interest and average return. Ignore the past-performance charts that show a three-, five- and 10-year average return; they are meaningless in building wealth. Stocks and bonds go up and down; only fixed vehicles compound.

Here’s how Wall Street’s double or nothing game works: A stock worth $100,000 that gained 100 percent in year one would grow to $200,000. However, if it lost 50 percent the second year, it would be worth $100,000. Your statement would reflect a 25-percent average return while your actual compound return was zero.

Let’s look at it a different way. In 2011, the average annual appreciation for the Dow Jones Industrials from 1900 to 2010 was 7.1 percent (which is how the Dow reports). So if one took a simple calculator and calculated what $1,000 invested over 110 years at an average of 7.1 percent would be, the number turns out to be $1,891,654. However, the Dow rose from 66 in 1900 to 11,578 in 2010, which reflects an actual compounded return of only 4.8 percent. Applying the same math example, the actual return of $1,000 invested in the Dow was only $156,363.

That’s an error of $1,735,291. Now that’s a lot of retirement money. The problem is, calculators and financial programs project future values using compound math and the investing public believes the numbers. The house is winning and we are losing. If you make that mistake, the only way to make up for it is to bet on Leicester winning.

John E. Girouard, CFP, ChFC, CLU, CFS, author of “Take Back Your Money” and “The Ten Truths of Wealth Creation,” is a registered principal of Cambridge Investment Research and an Investment Advisor Representative of Capital Investment Advisors in Bethesda, Maryland.

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