To determine how much you need to save on an annual basis to reach a financial goal, you need to know when you'll need the money and how much you'll earn on your investments. The typical approach to determining an expected rate of return is to look at average annual returns for some historical period. However, the average annual return can vary substantially, depending on the period used.

For instance, let's assume you're looking for an average return for the stock market as measured by the Standard & Poor's 500 (S&P 500). From 1926 to 2002 (77 years), the S&P had an average return of 10.2%. That return was 11.1% for the period from 1953 to 2002 (50 years), 13.0% from 1978 to 2002 (25 years), and 9.3% from 1993 to 2002 (10 years).*

While you might not think that a percentage or two would make much difference, consider what happens over the long term. If you invested $5,000 per year on a tax-deferred basis for 30 years, what would your expected balance equal using each of the above returns? Your potential balance would be $941,384 at 10.2%, $1,126,972 at 11.1%, $1,656,576 at 13.0%, and $787,902 at 9.3%. There are significant differences among those balances, even though all are based on average returns over a 10-year or longer period.

Even if you manage to select an average return that is exactly right, your portfolio's ultimate balance will depend on the pattern of actual returns over that period. Some years will experience higher returns than the average, while other years will experience lower or even negative returns. If you experience high returns in the early years when your portfolio's balance is low and then lower returns in the later years when your portfolio's balance is higher, you will have a smaller balance than if the opposite occurred.

So how should you select an expected rate of return for your portfolio? Consider these tips:

• Evaluate your expectations for future returns against historical averages. Based on recent market performance, it may be prudent to assume lower returns in the future. It's easier to make portfolio adjustments due to higher returns (you'll just need to save less) than to compensate for lower actual returns (you'll need to save more).
• Consider a range of possible returns for your portfolio. What would happen to your portfolio's balance if you achieved your expected return, 1% less, 2% less, etc.? This analysis can help you decide what adjustments would need to be made to compensate for lower returns.
• Review your progress every year. Assessing your portfolio's progress every year will allow you to make adjustments along the way. If your return is lower than expected, you may need to increase savings or change investment allocations.

* Source: Stocks, Bonds, Bills, and Inflation 2003 Yearbook, Ibbotson Associates. The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market. Investors cannot invest directly in an index. Past performance is not a guarantee of future results. Returns are presented for illustrative purposes only and are not intended to project the performance of a specific investment.

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