With the recent volatility creating instability in people’s portfolios and peace of mind, I thought I’d take a look at how the DJIA (Dow Jones Industrial Average) has performed over the last 30 years since 1975. In this time frame, the DJIA has it ranged from a high return of 38% in 1975 to a loss (-17%) in 1977. From 1975 to 2006, there were 23 positive years and 9 negative years. If you were to take a simple average of the annual returns over this time period, you would get an average return of 10.83%
Does this mean that you will get a 10.83% annual return when investing in DJIA? NO. Some years you will earn that or more, while other years you will earn less, even lose money. What your overall performance will be is not as simple as taking an average. Let me give you an example: two people invest their money in different financial instruments for 5 years. The first investor earns a fixed rate of 8% each year, while the second investor earns 15% (-3%), 18% (-12%) and 22% over the five years. Both investors have earned a simple average of 8% over the 5 years, but do they have the same amount?
Inverter 1:
Initial Investment $10,000.00
After the first year 8% profit $10,800.00
After the second year 8% profit $11,664.00
After the third year 8% profit $12,597.12
After the fourth year 8% profit $13,604.89
After the fifth year 8% profit $14,693.28
Inverter 2:
Initial Investment $10,000.00
After the first year 15% profit $11,500.00
After the second year (-3%) Loss $11,155.00
After the third year 18% profit $13,162.90
After the fourth year (-12%) Loss $11,583.35
After the fifth year 22% profit $14,131.69
As you can see, investor one made almost $562.00 more even though they calculated the same simple annual average. However, in real returns, the first investor earned 5.5% more over the five years of investment. I bring this example to show the value of minimizing negative returns. The best way to do this is by diversifying, not only across different stocks, but also across different asset classes. Finally, please note that historical data does not mean that the future will be the same, but can be used as a starting point to predict reasonable performance.
