A prospective client called me last week looking for a financial advisor who could provide a solid 7%-8% return on her investments. Apparently she had already called several other advisors and at some point was referred to me.
She wasn’t willing to take a lot of risk, but was pretty sure a 7%-8% return over the next five to eight years would provide the income she needed during that time.
Historically, a 7%-8% return seems reasonable. It’s not too hard to generate 7%-8% over a twenty year time period. The Dow Jones Industrial Index has averaged 8.85% per year from 1991-2011. The problem is no one knows what your return will be in the year that you need to sell the investments.
If you had invested your money in the Dow from 1991 and sold in 2000, you would have received a whopping 15.76% annual return. But if you happened to have invested your money in 2000 and sold in 2009, you would have earned a measly 0.55% per year.
Several obvious points come to mind:
- Investing in the stock market should only be considered if you don’t need your money for many years.
- Timing the stock market is a fool’s game. As noted above, winning and losing years in the stock market are completely unpredictable. If you take the largest gain for the Dow in 1995 (33.45%) and the largest loss in 2008 (33.84%), that’s a 67.29% swing!
- Picking individual stocks is dangerous. The Dow Jones is a diversified mix of our biggest, most innovative companies. It’s a good representation of our market economy. Do you think you can do better? Sure, you could have picked Apple stock 20 years ago, but you could have just as easily picked Enron… many did. Remember for every buyer there is a seller. Or maybe a more memorable saying is, for every winner, there’s a loser.
I responded to my prospective client by telling her that it was possible to earn an annual return of 7%-8% over the next few years. But it was also possible to lose 7%-8% or more over the same time period. Was she willing to take that risk?
I carefully explained to her that in the current market, getting a return of 2-3% was possible with just a little risk by purchasing high quality bonds and CDs for a portion of the portfolio. Getting a return over 3% was difficult without taking a lot of risk. Ultimately this prospect went on to make more phone calls.
The process of investing simply comes down to your time frame and risk tolerance. Do you have 20 years to wait out the ups and downs of the market? If not, are you willing and able to risk the potential loss that comes with investing in the stock market? If both answers are no, then you should not be expecting a safe 7%-8% return.
Why not just settle for a reasonably safe 2-3% return for the next few years? Then, as our economy improves, return rates will naturally increase with inflation as bond and CD yields rise. By using fixed income ladders and other low-risk investment strategies, you can preserve your principle while minimizing taxes and the impact of inflation.