Last month, I gave an “Introduction to Index Investing” presentation to the ChooseFI San Diego members. The above chart was one of the slides in my presentation. This chart shows you how much $100 is worth today (a little under $400,000) if you had invested it in the S&P 500 in 1928 (that’s how far back data is available for the S&P 500) and just let it grow. The S&P 500 is an index that measures the market value of the 500 largest companies traded on the U.S. stock exchange. The returns look pretty amazing, huh?
When I showed that chart to my sister-in-law during one of my practice runs for the presentation, she said that it was hard to believe $100 could grow to that much over a 90 year period. I know it seems a little unbelievable, but remember when I said compound interest is powerful? Yep. That’s the magic of compound interest.
[Side note: It’s believed that Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” Listen to this genius. I mean, he came up with the theory of relativity and the black hole more than a century ago before we even saw an image of it this week.]
Anyways, where were we? Ah, yes. The S&P 500. The compound annual growth rate (CAGR) for the S&P 500 is 9.73%. CAGR is the annualized return. You don’t want to use average returns when you’re talking about return on investment and annual growth because it can be misleading. Here’s why. Let’s say you invested $1,000. You get a return of 20% the first year, so now your investment has grown to $1,200. The next year, you saw a 20% decline, resulting in an ending amount of $960.
If you were to use averages, you would say that you got an average return of 0% since the 20% increase and 20% decline canceled each other out, but that’s not true. The CAGR, also known as the annualized return, is actually -2.02%, which would be a more accurate way of looking at the return on your investment over the two year period. See the difference?
In the chart above, the growth of the S&P 500 is reflected in the blue line. The growth of 10-year treasury bonds and 3-month treasury bills are reflected in red and yellow, respectively. If you were to invest in treasury bonds or treasury bills, which would have been very safe (i.e. very low risk), your investment would have been a slow and steady growth. $100 invested in treasury bonds would be worth $7,308.65 today and $100 invested in treasury bills would be worth $2,063.40. Low risk, low returns.
So how do you get returns that are equivalent to the S&P 500 (~$400,000 from $100)? It’s very simple. You buy an index fund that mirrors the returns of the S&P 500. (You can’t actually buy the S&P 500 because it’s just an index–a way to measure how the 500 largest companies perform over a period of time, but you can buy an index fund that tracks it and provides returns that are very close to it, minus any management fees charged by the investment company that created that fund.) An example of an index fund that tracks the S&P 500 is VOO.
That said, see that last line in the chart which reads, “Past performance is no guarantee of future returns”? Just because the stock market has returned 9.73% return in the past does not mean that it will return that much in the future, but the fact that the annualized return over the last 90 years has been 9.73% makes the stock market a pretty good bet.
BUT… (there’s always a but, right?) before you start dumping your entire life savings into VOO, you’ll need to learn more about the stock market and how NOT to lose money. Because your behavior, more than anything, is the single greatest factor that will affect whether or not you make money in stocks. I sometimes cringe when my friends ask me for stock tips. Sure, I can tell you what to buy, but if you don’t know what you are doing, you might do something like sell your shares when you shouldn’t, lock in your losses, and end up hurting your wealth. Don’t buy stocks based on reading one blog post or a ten minute conversation with a friend. There is a lot more to stock investing than just buying index funds. I’ll share more info. over the next few posts. Be sure to subscribe to my email list so you don’t miss out on future posts! And if you found the information on this site helpful, please share it with a friend or family member who could use that information. Sharing is caring. 🙂