The rarity of an “average” year

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Barring any big market swings in the last few days of 2010, the year’s performance will be pretty average. The S&P 500 is up about 9 percent for the year, very close to the index’s annualized total return of 8.8 percent for the period 1988 to 2009.

An average year doesn’t seem like it should be an oddity, but it is. This will likely be only the fourth time since 1988 that annual total return for the index has fallen between 6 and 12 percent. Return has been negative five times over that span and up more than 20 percent nine times. The best year was 1995 (up 37.58 percent); the worst was 2008 (down 37.00 percent).

By computing averages, we can capture long data sequences in just a few statistics. But we must be careful about how we use those averages. For instance, if we create a retirement portfolio based on the idea that the S&P 500 will go up a predictable and orderly 9 percent each year, we are ignoring risk and will likely be in for an uncomfortable ride with big peaks and valleys. The timing of those variations may result in a total portfolio value at retirement far above or below our average-driven expectations.

Instead of expecting average, investors should expect a probability range of returns. Monte Carlo analysis is a powerful computer simulation tool that runs thousands of permutations of performance based on the risk and return characteristics of a portfolio. Its output is a range of outcomes with probabilities attached. This data presents a much more realistic basis for planning. I feel it should be at the heart of all portfolio planning.

 

All historical returns from Wikipedia.

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