How are you measuring up with your investment return? (5)

Read? How are you measuring up with your investment return? (4)

Read? CS Global Investment Returns Yearbook 2012

What Are Normal Stock Market Returns?

How often in the last few years have investors said they’re staying out of the equity markets because of the volatility we’ve experienced recently? Many of them are waiting on the sidelines “until things are back to normal.”  That raises the question: what exactly is normal for equity returns? Usually when people think of “normal” [...]

By Canadian Couch Potato

 

How often in the last few years have investors said they’re staying out of the equity markets because of the volatility we’ve experienced recently? Many of them are waiting on the sidelines “until things are back to normal.”  That raises the question: what exactly is normal for equity returns?

Usually when people think of “normal” returns, they look at historical averages. According to the Credit Suisse Global Investment Yearbook, stock markets in the developed world delivered an annualized return of 8.5% over the last 112 years. Using that average as the midpoint in a range, it seems fair to say that “normal” historical stock returns are between 6% and 11%.

You might conclude, therefore, that it will be time to get back into equities once we’ve seen a couple of years with returns in this neighbourhood. That would be signal that things have “returned to normal,” right?

To test this idea, I looked at equity index returns for Canada, the US and international developed markets (in Canadian dollars) since 1970. Sure enough, during this 42-year period, annualized returns for all three asset class returns were within our expected range: 9.1%, 10.6%, and 8.9%, respectively. But what about year-by-year returns? If you were investing throughout these four decades, what years would you have considered “normal”?

Normal annual returns are extreme

You may be shocked to learn that a portfolio with equal amounts of Canadian, US and international stocks would have posted returns between 6% and 11% exactly five times in the last 42 years. Think about that: in any given year, the chance that stock returns will be within this “normal” range was less than one in eight.

Now let’s consider the probability of more “abnormal” outcomes. If the average long-term return for stocks is 8.5%, let’s look at years where returns were a full 10 percentage points more or less than that. It turns out that there were 11 years with losses of at least –1.5%, and 17 others with gains of at least 18.5%. In other words, the probability of a significant loss or a huge gain was 67%, or two years out of every three.

You can see all of these data by downloading my spreadsheet. You can also experiment by changing the upper and lower limits of what you consider “normal.” The spreadsheet will tell you how many years fall within your specified range.

In his outstanding book Debunkery, Ken Fisher looked at an even larger data set from 1926 through 2009 and found much the same result. The annualized return of US stocks over this period was 9.7%, and the simple average was 11.7%. But over one-year periods, returns almost never looked like this. Two-thirds of the calendar years produced returns of more than 20% or less than –10%. Returns were between 10% and 12% only five times in 84 years. “Normal annual returns are extreme,” Fisher writes. “It is hard to get people to accept the degree to which that’s true.”

Volatility has always been normal

There are a couple of lessons here. First, a “normal” year for stocks is one with very high or very low returns—and that has been true even since 2000. So if you are waiting until stocks can be counted on for a steady 6% to 11% return, you’re waiting in vain, because that has never happened. Sharp declines and soaring recoveries have always been normal. Any time you’re out of the market you’re safe from a sudden plunge, but you’re more likely to miss periods like the 13 months following the 2009 market bottom, when global stocks rose over 80%. Or, more recently, the period from October 2011 through this past March, when they rose almost 25% in just six months.

The second lesson is harder to hear. The “long term” is probably longer than any of us wants to admit. If you think it’s seven to 10 years, that’s fantasy. You have to look at rolling 20-year periods before there’s a very a high probability of equity returns close to that 8.5% average. That means if your time horizon or temperament prevents you from thinking that far ahead, you need to dampen your portfolio with an allocation to high-quality bonds or cash. This will likely lower your expected return, but that is the inevitable trade-off between risk and reward.

People will always try to get the upside without the downside, whether it’s through market timing, stock picking or more exotic strategies. But mostly they’re fooling themselves. As Ken Fisher writes after more than three decades as a wealth manager, “To my knowledge, no one has ever achieved market-like returns without some market-like downside. If you want to achieve something close to stocks long-term average, you must accept downside volatility. No way around that.”