Compounding depends on the ability to stick with your investments for a long period of time. Many investors, especially those who are just starting out, wonder where to put their hard-earned cash so that it will work for them over the long term. Taking a look at long-term returns on both savings accounts and stocks might give you a sense that stocks are the way to go, but it is not that simple, and there are many factors that you should take into account before investing your money.
Average Rates of Return
With the national average interest rate on savings accounts currently at 0.04% APY, many have been looking for investments that will give them better performance. Most basic savings are around 0.01%, and the highest yields are around 10% for top-tier high-interest savings. Over the past 100 years, average returns on the stock market have averaged around 10% before you take inflation into account. That would make the decision of where to invest seem like an easy decision, but not so fast.
Average Is Not Always “Average”
It is easy to look at these numbers and decide right away to close your savings account and dump it into stocks, but the first thing you have to consider is that inflation knocks about 2 to 3% off of the 10% return from the stock market. Another thing that you need to consider is that when you are looking at an average, it does not reflect data from any particular year. An average is made up of a range of numbers both above and below the average. For an investor, this means that you have to take into consideration both the upside and downside risk of an average.
I like to look at general market trends and long-term averages like the weather. It might be raining at your house, but a short distance away, it might be cloudy with no rain or even sunny. The weather in your local area will come and go quickly, but this will not have a major impact on average global temperatures. Yes, it is a contributor, but your local weather will affect your afternoon barbecue more than the average global temperature or temperatures in your region.
Your Actions Make the Biggest Difference
In a perfect world, every investor would start investing early and let their investment compound over time until it provided them a nice little nest egg when they retire. As we all know, it is not a perfect world, and investors do not always keep their money in the market over the long term. Life happens, and sometimes you have to dip into your nest egg.
Many factors play into why investing based on the law of averages can be a risky endeavor. The first is that market will fluctuate. There will be bull markets, and there will be bull markets. The biggest question is what actions you take during these market cycles. For instance, if you tend to buy on a bull market and then sell everything off in a bear market, the average rate of return means nothing because you consistently take losses.
The important thing to take away is that your investment decisions should not be based on generalizations and overall market averages that you hear on the nightly news. You have to realize that averages are not carved in stone and that fluctuations and individual decisions have more of an impact on your actual returns. While it is nice to keep track of what the market is doing over time, you should consider other information because averages are not always average.