Developing Realistic Expectations

Successful investors set realistic expectations by looking at long-term market performance. Stock and bond markets can be volatile. Securities don't always rise in value, and when they fall, the downturns can sometimes be lengthy. A thoughtful, diversified investment plan can give you a measure of comfort to help weather these downturns. It can also keep you from assuming risk beyond your tolerance when you're tempted to chase sudden, winning performers.

Long-Term Market Performance

As the graph below indicates, the U.S. stock market produced atypical returns during the 1990s compared to the market's historic annual average. Informed investors base their expectations on historic returns. If you set your expectations too high - for example, assuming 1990s returns - you will fail to reach your investment goals when the market reverts to historic levels.

U.S. Stock Market Average Annual Returns

Source: Ibbotson Associates, Inc.*

By the same token, if you're invested in the bond markets, when interest rates reach historic lows, it's reasonable to assume that the risk of a decline in your investment due to a rise in interest rates has just increased. Bond prices and interest rates move in opposite directions: when interest rates go up, bond prices go down, and when interest rates go down, bond prices go up.

Remember, too, that markets can move up and down quickly, and sometimes sharply. Although the average annual stock market return since 1926 has been 10 percent, many individual years have seen losses. For example, for the four-year period 2000 through 2003, the stock market lost an average of 5 percent per year.*

Regardless of the direction of the overall market, certain segments may perform exceedingly well while others may not. Don't let an unstable market environment tempt you into chasing short-term performance. Resist buying or selling investments unless they're part of your long-term plan.

Short-Term Market Movements

It may also be tempting to avoid market declines by trying to "time the market," that is, moving your money out of stocks when you think their prices will fall. Many studies have confirmed that this is generally a losing strategy. Your returns will be greatly reduced if you are not invested when the market goes up. History shows that buying and selling in an attempt to "time" the market typically produces much poorer results than simply staying in the market.

"Time in the Market" Versus "Timing the Market," 1963 - 1993

Source: University of Michigan

Most of the biggest market gains - as well as losses - occur during very brief time periods that are nearly impossible to predict. As the graph above indicates, an investor who stayed in the stock market during the entire 30-year period from 1963 through 1993 - 7,802 trading days - would have had an average annual return of 11.83 percent. But if the investor missed the 90 best days in an effort to time the market, the average return would have fallen to 3.28 percent per year. But can anyone predict the 90 best days during a 30-year period?

The short-term ups and downs of the market will be less worrisome if you keep in mind that you are investing to meet long-term goals.

Past Performance

Looking at past performance can help you understand how an investment has behaved in different market conditions and how it compares to other relevant performance measures and to other investments with the same objective. However, past performance cannot predict future results. This year's top-performing investments aren't necessarily going to be next year's winners.

The Bottom Line

It is important to remember that many factors - including your own expectations, goals, risk tolerance, and investment behavior - will affect your investment results. Developing realistic long-term expectations is key to establishing and maintaining a successful investment plan.