People put money in the stock market because they think that is where it will grow the fastest. We all know people who have made money in the market. We all, also, know people who have lost substantial amounts of money in the market.

Everyday the financial news gives details of individual stocks that have double or even tripled in just a few short weeks. If you had put $10,000 in the stock market in January 1970 it would have been worth $166,819 at year end 2007 (as measured by the S&P 500). In addition, you would have collected a growing dividend income over the years. Economic studies have repeatedly shown that the stock market has yielded an average annual return of 9% to 12% over long term holding periods. (see Ibbotson and others sources http://corporate.morningstar.com)

The stock market looks seductively easy, but it is not. What goes up, very often comes down and gives little warning when it does. In the latter half of the 20th century, economists developed statistical methods of analyzing stock market performance. If some of these procedures are applied to the thirty-seven year market period from 1970 through 2007, the results are as follows:

During this period the average annual stock market gain was 9.29% plus or minus 15.81%. The 15.81% is called a standard deviation, and it is a measure of the accuracy (reliability) of the 9.29% annual average gain. The greater the standard deviations, the more volatile or unpredictable the result. A standard deviation that is almost twice the average (as above) is not a good sign.

In what statisticians call a normal distribution, 68.27% of the time the results will fall with-in one standard deviation; 95.45% of the time within two standard deviations; 99.73% within three standard deviations. Please note we never get to 100%. There is always a chance that real life will do something entirely different than it has ever done before.

In other words, about 2/3 rd’s of the time the one year buy-hold stock market performance varied between a loss of 6.52% and a gain of 25.1% (9.29% +/- 15.81%). 95.45% of the time (two standard deviations) the outcome ranged between 22.33% loss and a 40.91% gain (9.29% +/- 15.81% times 2) and 99.73% of the time (3 standard deviations) the results were between a 38.14% loss (9.29% - 15.81% times 3) and a 56.82% gain.

The standard deviation overstated the potential for market gain and understated the probable loss. The total range of our 27 year period was a maximum loss of 41.4% between September 1973 and September 1974 and a maximum gain of 57.37% during the period June 1982 to June 1983. Historically, the market never reached the predicted 56.82% high. This discrepancy is partly because the market is not symmetrical. It does not go up and down in the same pattern. Economic theorists call this 'asymmetric volatility phenomenon (AVP). It is also partly because statistics are an imperfect tool. However, statistics are the best guide we have to unravel the economic lessons of history. Consumers need to be aware of their limitations when they use statistical estimates in retirement planning.

Note: Professional investment managers have developed sophisticated tools for dealing with AVP and the risk is represents to portfolio values. These tools are complex and beyond the scope of this discussion.

This study assumes the purchase of a broad cross-section of stocks at the closing price on the last day of the month, and that the stocks were sold on the same date and time exactly one year later (adjusted for weekends and holidays). This provided 444 one year buy and hold periods. (Jan 1970 to Jan 1971, Feb. 1970 to Feb. 1971, etc to … Dec 2006 to Dec 2007). The study did not take into account dividends that would have been paid on the stocks during the year and it completely ignored the impact of income taxes on any gains or losses. (See note below about the study)

The stock market has delivered impressive profits to many investors. However, it has also destroyed a lot of nest eggs. Ignore the annual gains in the above study for a moment and focus on the losses. The chance of loss is substantial. There are billions of retirement dollars committed to the stock market. Pensions, profits sharing plans, 401k’s, and individual IRA’s all have significant portions of their portfolios in preferred and common stocks. However, the market is such a risky place, that each year American’s spend hundreds of millions of dollar on risk management techniques that are designed to protect those billions of dollars from catastrophic loss.

From 1970 through 2007 the stock market was down 40% of the time on a month-end to month-end basis and 24% of the time in annual holding periods. If the market declines 20%, you need a 25% gain, just to get break even (see Stock Market Math). If your retirement goals require an annual growth rate of 8%, then a 20% market decline puts you 26% behind your annual target. Assuming the market recovers within one year, you will need a 35% return to get back to your 8% growth goal (remember you only have 80% of your funds left after a 20% downturn, so they have to work harder). If the market is down over a two year period, you will need market growth of almost 46% to get your retirement plans back on track. See Stock Market Math

Note: The purpose of the above study was to measure stock market probabilities and to derive a statistical sample. Nothing in this discussion should be construed as a recommendation for any course of action either specific or general. There are no guarantees that the stock market performance after the sample period, or before the sample period, will yield similar statistics. It is also possible that a different holding period would have radically changed the results. The data used was obtained from a sources believed to be reliable, but it is possible that our data sample contains errors and those errors would therefore be reflected in our results. The data used reflects the market actions of about 75% of US traded stocks as measured by their capitalization. Also, only a limited number of statistical measures were calculated. Interested individuals should conduct their own investigations using analysis tools appropriate to their situation. A spreadsheet ready copy of our data is available to any interested party. ??Email??