With the start of a new year, it’s only natural for investors to reflect on the previous year and try to make some determination about whether or not it was good. Part of that process usually involves comparing our returns against those of a neighbor or of and index like the S&P 500. Unfortunately, these types of comparisons usually are misleading and cause a lot of frustration.

Instead of these types of comparisons, professional money managers generally aim for a specific percentage gain. For example, the target for a conservative account might be 6% or 10% for an aggressive account.

A former colleague is now working on the East Coast managing a pension fund with more than $300 million. In 2006, the S&P 500 was up about 15%. So what do you guess would be a satisfactory return for this pension fund? Twenty percent? Twenty five? The fund’s actual return in 2006 was 11% and that return was good enough to ensure that everyone involved got substantial bonuses. Their annual target return is 8%, which happens to be a very good return over the past several years. Since the start of 2000, any manager who has earned an average annual return of 8% would be wooed by some of Wall Street’s biggest firms.

(One interesting side note, when this pension fund has positions that aren’t doing too well, the manager tends to invest more money in those holdings rather than reallocating to the better-performing positions. That is the exact opposite approach that most individual investors take.)

Investors tend to have short-term, selective memories. Over the past six months the stock market has done fairly well. As a result, many of us are starting to have unrealistic expectations about how much our investments should be earning.

Let’s bring everyone back down to earth with an examination of what the markets have really been like in recent years. The chart below shows a comparison of the S&P 500 (black line) and the Nasdaq (gold line) since the start of 2004. Notice that over that entire three year period, the S&P 500 is up about 26% and the Nasdaq is up about 22%. So that is an annualized return of about 8% and 7% respectively. That doesn’t seem too bad. But that number is a little misleading because investments do not advance at a steady rate.

Look mid-July of 2006. At that point the S&P 500 was up just 10% over 2.5 years and the Nasdaq had advanced just 1%. So the bulk of the gains for these indices occurred in the past six months. And if you look at the overall choppiness of these indexes for the past three years you see that it would have been very difficult to make any money at all until the past six months. In fact, in July 2006 the Nasdaq was lower than in January of 2004!

Now let’s take a longer view, back to the beginning of 2000. In 2006 there was a lot of news coverage devoted to the Dow making a new all-time high. But remember, the Dow is just 30 stocks and is a very narrow index. Obviously the S&P has 500 stocks and the Nasdaq has more than 3,200. So these indexes are probably going to give a more accurate view of how the overall stock market is faring.

As you can see on this chart, since the beginning of 2000 the S&P 500 is down about 5% and the Nasdaq is down 40%. Suddenly 8% a year doesn’t seem so bad!

Like so many things in life, investing is all about timing. Someone who started investing in 1995 probably made a ton of money by the end of 1999, no matter what investments he chose. But an investor who started in 2000 is lucky if he has broken even between then and now.

The past couple of weeks I’ve written about weakness that the Nasdaq is currently experiencing. But so far the index has managed to stay above critical support levels. And the S&P 500 and the Dow are doing better than the Nasdaq. Economic fundamentals remain strong. So while we will probably see more sideways market action, I do not anticipate a major correction. Certainly investors need to be cautious right now, but there are no technical or fundamental indicators pointing to an imminent bear market.

With the lower price of oil and the Federal Reserve no longer raising interest rates, 2007 could easily turn out to be the best year for investors since 2003. Keep your fingers crosses and hold your positions.

F.S.