Why it's essential that you invest outside the FTSE 100

Financial experts often advise that as an asset class, shares will generate returns of 8%-10% per year over the long term. As a result, many individuals base their retirement planning around these calculations.

However if you've been relying on the FTSE 100 index to generate this kind of return on your capital, I have some alarming news for you. Over the last decade, the FTSE 100 has not generated that much. In fact, the index hasn't generated anywhere near this return. Admittedly, a decade ago markets were near all-time highs and since then we've experienced the Global Financial Crisis as well as several other periods of high volatility. However, if you're relying solely on the FTSE 100 to fund your retirement, the returns may not be as high as you're anticipating.

Let's take a closer look at the blue chip index's performance figures.

Dismal returns

It's fair to say that over the last decade, the FTSE 100 has been an underachiever.

Take a look at the tables below which show the yearly returns of the FTSE 100, the FTSE 250 and the S&P 500.

Capital appreciation return (not including dividends)

Total return with dividends reinvested

(Return figures sourced from Bloomberg and calculated up to the end of March 2017)

The tables show, that over the last decade, the FTSE 100 has returned just 1.5% per year on a capital appreciation basis, and 5.4% with dividends reinvested. By contrast, the mid-cap FTSE 250 index has returned 4.6% per year on a capital appreciation basis and 7.9% with dividends.

I've also compared the two indices' performance to the S&P 500. The US index has outperformed the FTSE 100 over five, 10 and 15 years, returning 5.2% a year or 7.5% with dividends reinvested over the last decade.

Key takeaways

To my mind, there are several fundamental takeaways from these performance figures.

The first involves diversification. It would appear that to achieve the coveted 8%-10% per year over the long term, you really need to invest outside the FTSE 100 index. To be properly diversified, a portfolio should have exposure to different geographical regions and market capitalisations. Many investors suffer from 'home bias', preferring only to invest in locally-listed stocks, but having exposure to international stocks could potentially boost portfolio returns.

Similarly, adding exposure to a mid-cap or small-cap index such as the FTSE 250 could also drive portfolio returns higher. High-quality smaller companies generally outperform their larger peers over the long term, and by having exposure to this area of the market, it could make a significant difference to your performance figures in the long run.

The figures also highlight the importance of dividends. Many investors ignore dividends, focusing on capital growth in an attempt to build wealth quickly. However, dividends when reinvested, consistently make up the bulk of total investment returns over the long term. It's therefore important to focus on generating dividends and reinvesting them.

So don't always rely on experts' assumptions when building wealth for the long term. While you would think that an index of 100 stocks would provide a suitable level of diversification capable of generating strong long-term returns, this has not been the case over the last decade.

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Edward Sheldon has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.