asset allocation, behavioral finance, finance, historical stock returns, investing, investments, long term investing, mathematics, performance, personal finance, portfolio, S&P 500, S&P 500 historical returns, S&P 500 Index, stock market, stock returns, stocks, uncertainty
All financial professionals providing advice urge individual investors to have a long-term plan and orientation. This advice is solid and has proven itself over the long term. However, no one really explains what it means to be a long-term investor. Most of the information dispensed is only a cursory review of the concept. The majority of new individual investors are then left without a full understanding and a comfortable feeling that a long-term investment strategy will work out in terms of allowing them to reach their financial goals. Since the importance of long-term investing is so integral to financial planning, I would like to delve very deeply into this topic. Therefore, I am going to cover this information as a three-part series of posts. This first post will discuss the nature of stock market returns. The second and third posts will address volatility in stock market returns and the perils of market timing, respectively.
Let’s get started on this journey and talk about stock market returns over the long term. Wherever possible I am going to use tables and graphs to better visually depict the concepts discussed in this post. But first, we must address one of my “pet peeves”. The proxy for this post for long-term investing will be the historical returns of the S&P 500 Index (including reinvestment of dividends). Why is this a “pet peeve” for me? I see too many articles in the financial press that look at historical returns for this index that go back to the 1920’s. You might want to know why this is a problem. Well, the S&P 500 Index was created back in March 1957. The S&P Index was started in 1926 but only included 90 stocks. Many articles in the financial press use the 1926 date as the starting point for analyzing historical stock market returns but that is really comparing “apples to oranges”. Additionally, as of September 2019, the S&P 500 Index includes 505 stocks grouped into 11 different sectors. Up until fairly recently, there were only 10 sectors but Standard & Poor’s made the decision to reclassify several of the stocks.
Now that we have dispensed with the preliminary comments, we can get back to the main discussion of part one. As you probably know already, the value of stocks fluctuates quite a bit over the course of a year. In fact, the financial media and financial professionals discuss these fluctuations on a daily basis. But even on an annual basis, stock market returns vary vastly over time. The long-term stock market return of the S&P 500 Index from 1957 through 2018 has been approximately 9.8%. Oftentimes Financial Advisors or Certified Financial Planners (CFPs) will tell their clients that they can expect to earn 8% to 10% by investing in stocks over the long term. While that information is true, it does not tell the entire story and subsequently leads individual investors to sell stocks during major market declines and buy stocks during periods of euphoria. Why is that the case when individual investors know up front that stocks will earn 8% to 10% over the long term but be volatile from year to year?
The main reason is that financial advisors mostly fail to fully explain how much stock market returns will fluctuate every year. In any given year, there will only be about 10% of stock market returns that fall into the bucket of being between 7% and 12%. To put that number into perspective, you can think of it as saying that only 1 in every 10 years can you expect to see stock market returns around the long-term average historical return of the S&P 500 Index. Now this information is very disheartening to both novice and more sophisticated individual investors alike. If you were told to expect that your yearly stock market returns would only be about average every 10 years, wouldn’t that be very helpful information to have in the beginning? My personal conjecture is that individual investors see that 90% of the time stock market returns are “abnormal” which causes them to react irrationally (or you might even say rationally since nobody told them it was likely to occur).
In order to “set the record straight”, I would like to show you a series of tables and graphs to depict what historical stock market returns of the S&P 500 Index have been over the last 61 years. My goal is not to dissuade you from investing for the long term; rather, I hope to persuade you why you should invest for the long term. After reviewing how stock market returns vary over different lengths of time, it is easier to understand what to expect and set more realistic expectations for your portfolio of investments. In order to accomplish this goal, I am going to show you a series of graphics regarding historical stock market returns. The information will show one-year, three-year, five-year, and ten-year data. The data with timeframes longer than one year will be annualized. “Annualized” is a fancy way of saying that the stock market returns are shown in a comparable way with yearly returns.
So, we will start off with an explanation of how I have grouped the data for stock market returns. I have broken up the returns for any period into “buckets” with a range of 5%. For example, there will be one “bucket” for any year where returns are between 7% and 12%. On either side of that main historical average bucket, I will extend the range in increments of 5%. For instance, there will be another “bucket” to capture returns between 2% and 7% and also another bucket to capture returns between 12% and 17%. Lastly, due to the fact that stock market returns have fluctuated so much over time, there will be two “buckets” to capture more extreme returns of less than -13% and greater than 22%. Showing how stock market returns for various periods fit into these “buckets” will be very instructive in deciding how to approach long-term investing.
The first way to view things is with a table of stock market returns. Note that these will be supplemented by graphs below for an even better visualization. Here are how stock market returns appear in each “bucket” as a percentage of time that they occur below:
There are two main takeaways after looking at the above table. First, the distribution of stock market returns over the course of one year are quite wide indeed. Plus, you can see how people can get very euphoric about buying stocks when the investment returns are higher than normal. The return of the S&P 500 Index has been greater than 22% about 29% of the time. Let’s put that percentage into a yearly equivalent which is, that in 1 out of every 4 years the stock market return will exceed 22%. It is hard not to get excited and want to buy more stocks when an individual investor sees that. Second, the distribution of stock returns for five years and ten years gradually shifts away from the extremes and toward the long-term historical average. Now this might be intuitive since the average must come about after longer periods of time are taken into account. More importantly, neither the 5-year returns or 10-year returns have fallen into the -3% and below “buckets”. If you have a long-term investment horizon, there will be more returns that appear within the “bucket” historical average for the S&P 500 Index. Using 10-year returns, they fall into the 7% to 12% “bucket” 32.1% of the time. And in our now familiar conversion to a yearly equivalent, you can expect to see any given 10-year annualized average return be just about inline with the historical average 1 out of every 3 years. Note that, even with such a long-term period, 2 out of 3 years will be outside of the expected historical average given the last 61 years of stock market returns.
In order to better absorb the information from the table above, here are four graphs that show the breakdown by period grouping in the various “buckets”:
The four graphs above show how the number of returns gradually centers more and more around the historical average for the S&P 500 Index as the time period is lengthened from one year to ten years. Moreover, the extreme outliers to the downside (returns less than -3%) are not present in the graphs for five years and ten years.
Now a historical side-by-side comparison makes it even easier to see that convergence to the historical average and removal of the outliers. I have left out the graph for three years only to reduce the amount of information shown on the following graph.
By carefully studying the table and various graphs depicted above, it becomes more palatable to become a long-term investor. I am a big believer in having realistic expectations prior to investing and building a portfolio of assets to buy and hold. Without knowing how much of a distribution there is in stock market returns from year to year, it becomes much harder to stick to that financial plan. Now do not get me wrong here, actually experiencing periods of extreme outliers (especially to the downside) when you have money at stake is nerve-racking to put it mildly. However, you have a much better understanding of what is “normal” in terms of annual returns. But, always keep in mind, that past performance in not indicative of future performance. With that being said though, it helps to have over 60 years’ worth of data to develop your investing strategy and determine your tolerance for risk (i.e. volatility of returns) going forward.
The topic of risk will be covered in the second part of this series on becoming a successful long-term investor. That topic and the last topic are covered by most financial professionals, but I would like to show the data in a somewhat different and unique way.