Over the last several months, I’ve read a ton of personal finance material, and it all keeps coming back to the same idea that basically says if you want to make big money, you have to invest in stocks, but as you approach your goals, you should move gradually to safer investments like bonds and treasury notes. I began to wonder how true this statement is. Do stocks really provide that much of a financial gain compared to other investments? Right now, I can buy long-term certificates of deposit that earn about 6% or so; is my money better off there?
To figure this out, I went and downloaded long term annual results of the Dow Jones Industrial Average and played around with it a bit. I figured out the percent increase each calendar year (up through 2006) and then figured out the average return over several different time frames. Here’s what I found:
Over the last 100 years, the Dow returned 7.49% in an average year.
Over the last 50 years, the Dow returned 8.40% in an average year.
Over the last 20 years, the Dow returned 10.66% in an average year.
Over the last 10 years, the Dow returned 7.79% in an average year.
Over the last 5 years, the Dow returned 5.47% in an average year.
Over an average year in the long-term history of the market, a stock investment will return better than a 6% CD investment. But in the last five years, you would have beaten your stock investment in the Dow if you had purchased a 6% certificate of deposit.
Here’s the deal: the stock market can and usually does beat other forms of investment, but when you invest you take on a risk that your return won’t be as good. An investment in stocks is not a guarantee of a good return over the short term, but over the long term you will eventually do well with stocks.
It is because of this short term risk that, as you reach your financial goals, you should move your investments into more stable forms such as treasury notes. Even though these investments won’t reach the return peaks of the stock market, they also won’t have the terrible valleys, either. That way, a major downturn in the market (the average annual rate of return for the five years between January 1, 2000 and December 31, 2002 – a three year period – was a whopping -10.03%) won’t wreck your finances.