If you’ve ever done any research on stock market investments, you’ve probably read that the average annual return is 7%. After all, even Warren Buffet himself claims that you should expect to receive a 6-7% annual return when you’re investing in stocks. So how do financial experts get to this number and when is it applicable?
When is the 7% average stock market return applicable?
While you can expect the average return on your stock market portfolio to be about 7% annually, this number is only applicable if two rules are followed. First of all, you need to be investing in stock markets for 10 years or more in order for the 7% average return to be reasonable. As you probably know, the stock market is incredibly volatile and it’s not just individual stocks that are unpredictable - returns vary widely by year too. For instance, during a financial crisis a large number of stocks can lose up to half of their value, on the other hand, in good years the return on stocks can be much higher than 7%, so you need to invest for at least 10 years for the numbers to even out.
Secondly, the 7% stock investment return rate is only applicable if you have a diversified portfolio with a large number of different stocks - you can’t expect this rate of return if you’ve only invested into a couple of stocks.
Why is the average stock market return considered to be 7%?
According to Warren Buffet, one of the most influential financial gurus, the number comes from simple calculations: the GDP, or the gross domestic product, which is a measurement of the economy of a country, is expected to grow on average by 3 percent every year and the annual rate of inflation is expected to be 2%. This brings the expected average stock market return to 5%, while additional dividend payments from companies add an extra 1-2%, bringing the total to 6-7%.
What were the historical stock market returns?
When reading about the 7% average stock market return, you may think that the market will significantly outperform this prediction because, in the past, stock market returns have been much higher. For instance, between 1982 and 1999, the stock market grew 18 perfect every year on average. However, in the low-inflation financial reality of today, those numbers are simply impossible. Additionally, if you look at the long-term stock market returns, the average annual return from 1950 to 2009 was exactly 7% when taking into account inflation and dividends.