Past Performance Is Not A Guarantee Of Future Returns

Quite often on The Simple Dollar, I’ll put up a description of a financial situation that one of my readers finds themselves in, or I’ll create a straw man to illustrate the point. I’ll give an age and a situation, and then apply an investment choice to that person to see what happens when I knock over the dominoes.

Invariably, someone will comment that the assumptions about some aspect of the illustration is wrong. “You can’t possibly expect to earn 12% over the long term in the stock market,” one person will say. “Only assuming 5% wage increase each year? Anyone with any gumption will beat that,” says another. “What if the person gets fired?” says yet another person.

And they’re all correct. If you change the assumptions around so that the situation is as they describe, you do draw a different conclusion, and the assumptions that they provide are realistic.

So what’s the point of looking at such situations in detail, then? The point isn’t to convince everyone that they must invest in a Roth IRA, even though it’s a good idea – one can always create some situation where it doesn’t make any sense. However, by looking at real situations, one can see the benefit of investing in a Roth IRA.

One particularly good example of this is with my recent MSN article on how to retire at age 40. In it, I made a number of positive assumptions about investments to illustrate the idea that a young person, if they were serious about investing, could actually retire at age 40 and do whatever they pleased. The purpose of the article was to illustrate that if you’re a financially prudent person, you don’t have to spend your entire life working and following the rat race, but it takes some discipline to do it.

In response to that MSN article, another blog, Mighty Bargain Hunter, took another look at some of the assumptions in the article, pointing out that they were in fact very positive assumptions, and then re-running the whole idea, revealing that retiring at age 40 might not be as simple as I made it in the article. And he’s completely correct – with a very realistic (perhaps slightly pessimsitic) set of assumptions instead of the more rosy ones I used, it will take much longer to retire.

Another favorite of mine is the ongoing debate over the Vanguard 500. The Vanguard 500 is an index fund started in 1976 that precisely mirrors the S&P 500, a collection of the stocks of most of the largest companies in the United States. Since its inception, it has averaged a return of over 12% per year. Given that, I often use a 12% annual return as a number to use to calculate annual returns in the stock market over a long term (longer than ten years).

Routinely, a blog commenter will comment that there’s no way that the S&P 500 will continue at this rate. They’ll use their own evidence by using a longer period of time than that, including S&P 500 returns from before 1976, or they’ll state an economist’s predictions about the future of the stock market over the next several years.

I will never be bold enough to say that I’m absolutely correct and the 12% annual average will hold up, but if you ask me what I thought, I’d say that it will, at least for a while, and I’d dump several reasons on your lap. Someone else would likely disagree with this and deliver several reasons why it won’t happen. I know at least one person with a degree in economics who firmly believes that the next several years will be much better than 12% as several new industries come online with marketable products. Who’s right? Only the future can really tell.

What can we learn from this? Any time you read an sample story about someone’s specific situation – whether it’s on The Simple Dollar, in Money Magazine, or anywhere else – know that in order to actually tell a story, you have to make some assumptions. No one knows what the future may hold in any financial situation. The person in question could get a new job tomorrow that raises their salary significantly, or they could get a pink slip. The stock market’s bottom could fall out, or we could enter into an incredible bull run where everyone makes a mint.

All we often have to base these scenarios on is the past, and past performance is never a guarantee of future returns. You can make up all the scenarios in the world, but if the stock market takes a giant lurch or someone discovers a universal cancer cure or solves the traveling salesman problem, almost all of them will be shattered.

So why have a scenario at all? Every scenario teaches something. It shows what can happen if you save money or if you spend it. It shows what can happen if you save for retirement. It shows what can happen if you make more frugal choices. It can turn a vague idea into something we can all imagine – and when that happens, it becomes something we can all reach for and hope to touch. Scenarios put a face onto ideas, and by putting on that face, it turns an idea into something we can relate to.

When you read another story about Joe and his financial choices, remember one thing: Joe’s no different than we are – he just wants to make the best choice for his future, something we all want to do.

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