The prospect of doubling your money is always alluring. Doing it in only seven years is even better.
That's what draws investors to the stock market. It has proved to be the most reliable place to build up savings over the long run.
The math seems to be there, at least. Invest $10,000 at an annual growth rate of 10 percent, and with compounding, it swells to $19,487 over seven years. After eight years it totals more than $21,000.
Of course, there's the caveat that there aren't any guarantees in investing. Witness the past decade, when a $10,000 investment was reduced to $9,000, including dividend income, by the end of 2009.
Yet that lost decade was an anomaly. The notion of stock investments doubling in about seven years is based on historic average annual total returns of 9 to 10 percent. With the required caveats, that amount is frequently cited in investment company literature, based on data going back several decades for the Standard & Poor's 500 stock index. The total return reflects appreciation in stock prices, as well as regular dividend payments.
But investors planning for retirement would be foolish to expect their stock portfolios to grow by as much as 10 percent a year, over the long run, says John C. Bogle.
The 82-year-old founder of the Vanguard Group and index mutual fund pioneer says most investors should expect just 1 or 2 percent a year from their stock investments. That's because the 10 percent that many investors anticipate doesn't factor in various costs that cut into their actual portfolio returns.
"People ought to be very conscious of the mathematics of investing," Bogle, who now runs Vanguard's Bogle Financial Markets Research Center, said. "But they so often ignore it."
He acknowledges that his 1 to 2 percent return calculation isn't a hard rule, because it's based on many of the variables affecting market performance. But it's instructive for understanding why an investor's net returns pale in comparison to market returns.
Here's a look at Bogle's math:
Stocks have averaged 9 to 10 percent gains, but Bogle figures 7 percent is more realistic over the next several years. He cites the current muted forecast for economic growth, as the nation slowly recovers from the recession and struggles to get government deficits under control.
Subtract at least 2 percent for inflation, and the annual gain shrinks to 5 percent. Historically, inflation has averaged 2 to 3 percent. That's in line with current inflation -- the rate fell to zero during the recession.
Bogle says most investors should subtract an additional 2 percent, to cover expenses for professionals who manage money, advise investors, and handle trades. The investor's return is then shaved to 3 percent.
Even if you're not an active stock investor, consider that the average expense ratio charged by managed stock mutual funds last year was 1.45 percent, according to Morningstar. That's the amount investors pay each year, expressed as a percentage of a fund's assets.
Expenses charged by index mutual funds were about half as much, averaging 0.73 percent. Index funds seek to match the market rather than beat it, and charge lower expenses because they don't rely on professionals to pick stocks.
In addition to ongoing expenses, many mutual fund investors also pay one-time charges called loads -- commissions paid to invest in a fund. Investors can also ultimately bear additional costs when fund managers trade stocks.
The remaining 3 percent return can shrink further if investments are held in a taxable account, rather than a retirement account like an IRA or 401(k). When fund managers sell investments that appreciated in value, they pass on the capital gains to investors each year. These gains are taxed unless held in a tax-sheltered account. Bogle figures investors with taxable accounts can expect to shave off another 1 percent from their return, leaving just 2 percent.
What's more, many investors cancel out that small return, or end up with losses, by making rash decisions. Studies show most investors have poor timing. A common scenario: An investor buys a mutual fund based on its recently strong returns. The market shifts, the fund's manager is late to respond, and the investor's return reflects the subpar performance, rather than the prior market-beating numbers.
Bogle advises that investors pay special attention to limiting the costs they can control, by choosing a low-cost index fund, and holding it for the long haul. "Costs, and minimizing them, are the driving forces in any investing equation," Bogle says.
His calculations aren't meant to imply that investors should abandon stocks. Despite their volatility, stocks are the best means to ensure that savings outpace the rise of inflation. Rising prices take a proportionally bigger bite from bond portfolios. That's because, historically, bond returns have lagged stock returns.