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I am trying to understand where the famous average return rate of about 10% of the S&P 500 comes from. In most conversations, the usual starting date is on 1965. Its averaging closing value at that time was about 88.16$. Today (2022), it is at 4,343.56$. I then naively attempted to see what the annualized return rate should be to go from the former to the latter (final = initial*(1+x)^years), but I only find something a little over 7%? I then instead tried to look at the return rate per year, from 1965 to 2022, and made an average out of that. This gave me a little over 8%. In any cases, I fail to get to the stated 10%?

I see in some documents that they always state to "include dividends", which may be the source of the error, but this confuses me since the S&P 500 is an index fund and not a single company that could pay dividends?

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    Where have you heard about 10 % a year?
    – Bernhard Döbler
    Jun 12, 2022 at 11:05
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    @BernhardDöbler yes, always good to show an example of a claim if possible. Looks like businessinsider.com/personal-finance/… for example indicates a 10.7% longterm average return, albeit with its numbers suggesting a start year of 1957.
    – JeopardyTempest
    Jun 12, 2022 at 17:59

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In most conversations, the usual starting date is on 1965.

This would be a period that is relatively short (57 years) in terms of major market cycles and that begins (in 1965) at the end of a major bull market, with stocks entering a period of stagnation (until the next major bull market starts in the early 1980s). Thus, 1965 is an "unlucky" starting point (buying around a peak) and returns since then are a bit below the long-term average.

It is common to start in 1926, when extensive data started being kept. This encompasses several entire bull and bear cycles, and corresponds to an average return of about 10%. Note, however, that this may itself be skewed, as the 20th century is a unique historical period in which stock investing became "mainstream".

I see in some documents that they always state to "include dividends", which may be the source of the error, but this confuses me since the S&P 500 is an index fund and not a single company that could pay dividends?

The widely quoted S&P 500 is a price index that indicates the appreciation of its component stocks but does not include the dividends they pay. If you actually invest in the S&P 500, whether as an index fund, ETF, or the component stocks, you earn dividends above and beyond the price appreciation. Thus, evaluation of stock market returns should indeed use a total return index that includes these dividends.

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  • In that case, I would assume that the total return would then depend on the specific index fund/ETF you buy, since, while they may track the same index, they do not all buy the same amount of dividends?
    – Patrick.B
    Jun 14, 2022 at 20:07
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    @Patrick.B The dividends are determined by the amount of each component stock held, which is determined by the composition of the index. Thus, any reasonable means of tracking the S&P 500 would result in a similar dividend yield and total return, up to minor cost differences (fund management fees may be deducted from the dividends you receive). The dividends really are intrinsic to the S&P 500, even though their effect is omitted from the way the index is usually quoted (just as comparing the raw price of an individual stock over time doesn't show the contribution of dividends).
    – nanoman
    Jun 15, 2022 at 0:46
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I see in some documents that they always state to "include dividends", which may be the source of the error, but this confuses me since the S&P 500 is an index fund and not a single company that could pay dividends?

Firstly, the S&P 500 is a stock index, not an index fund. There are many index funds that aim to track the S&P 500 index, but the S&P 500 itself is not an index fund. You cannot buy the S&P 500 index, but you can buy an index fund that aims to track it.

Secondly, most index funds that aim to track the S&P 500 index do so by replicating the S&P 500 index. They do this by holding more or less the same stocks that are part of the S&P 500 index. These stocks pay dividends. This is where the dividends come from.

Thirdly, there are a few variants of the S&P 500 index. The Price Return S&P 500 index (SPX) is what you see all the time in financial news, but it does not include dividends in the returns. The Total Return S&P 500 index includes dividends in the returns. Therefore, to do your calculation, you should use the Total Return S&P 500 index.

Refer to Are the S&P 500 and DOW "performance index" or normal/price index? for more details about the different variants of the S&P 500 index.

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