What Are Normal Stock Returns?

if you're investing in stocks and bonds you have surely wondered how your portfolio was doing and how you should expect it to do going forward performance is relative we would evaluate an active fund manager against an index to see if they're delivering better returns than passively holding the market they rarely do if you are already investing in the index through a low-cost index fund you would expect to get the market's return net of fees that is easy to say but it's a bit harder to understand what the market return has been in the past and what we should expect it to be going forward are two of the most important questions in investing I'm Ben Felix associate portfolio manager at PWL capital in this episode of common sense investing I'm going to tell you about past and expected financial market returns [Music] as investors we care about market returns because they are one of the big unknowns and planning for the future how much you need to save when you can retire and how much you can spend in retirement are all heavily affected by the real rate of return on your investments real meaning after inflation the importance of stock returns makes them a focal point for investors and leaves many people wondering both how their returns have been and what they should expect them to be in the future we know little about the future but in 2018 we are blessed with easy access to the data that allows us to understand the past the credit suisse and global investment returns yearbook gives us data on stock returns going back 118 years to 1900 it is updated every year this study includes real returns for 23 countries expressed in US dollars for the full period real equity returns for the global portfolio were 5.2 percent that is 5.2 percent in excess of inflation this number includes total losses for Russia in 1917 and for China in 1949 after going to zero both of those countries return series were reintroduced to the index in the 1990s so going back as far as we have reliable data even including two stock markets going completely to zero real returns have been 5.2 percent on average per year since 1900 now that we know that stocks globally have beaten inflation by 5.2 percent per year we might have a better lens to assess the returns that we get any given year we might also be armed to develop expectations about the future the challenge is that well those figures may be accurate over very long periods of time they tell us nearly nothing about what we can expect in a given year even a 10 year period is not sufficient to be sure that you will get returns that resemble the long-term averages for example we have talked about the average risk premium for stocks being a little over 4% over the long term if we look at rolling 10-year periods the story's much difference in the US stocks have underperformed Treasury bills 15% of the time over rolling 10-year periods going back to 1926 the same is true for Canadian stocks going back to 1970 10 years is not a long time in stock market history but it is a long time for an individual to wait for positive risk-adjusted performance typically investors are myopic likely evaluating their returns at least annually and probably more frequently despite having a longer-term goal the dispersion of stock returns in any given single year period is all over the map I don't have data going back to 1900 but I do have data going back to 1974 Canadian international and US stock market indexes in that 47 year period the compound average returns after a Canadian inflation and in Canadian dollars were 5.2 2% for the S&P TSX composite index 5.26 percent for the MSCI EAFE II index and 6.9 6% for the S&P 500 index those figures are pretty close to the long-term global average for returns well that finding is interesting it does almost nothing to tell us what a normal return might be in a given year in all three markets the average return was earned in exactly 0 of the 47 years in the sample if we expand the range of what we want to call normal real returns to between 3 percent and 10 percent Canada had 11 years in that range the u.s. had 6 and international markets had 7 think about that the majority of annual real returns for an equity investor since 1970 have been less than 3% or greater than 10% expanding the range that we are calling normal to between minus 8 percent and plus 15% ends up encompassing about half of the annual returns for each market that means that the other half of annual returns were either very positive or very negative years based on that it is safe to say that what we might want to refer to as an extreme return that is below minus 8 percent and above 15 percent should be considered very normal as an investor this makes it important to do a few things have at least somewhat of a grasp on the historical data normal returns are random and extreme and that is what we should expect in any given year choose an asset allocation that you can live with in a worst-case scenario keeping in mind that the worst case scenario may well be worse than anything that we've seen in our lifetimes most important stay invested regardless of how bad things look even if the market is crashing there is no reason to believe that trying to avoid the downside will make you any better off on the contrary there is plenty of evidence that trying to avoid the downside will make you worse off Peter Lynch has claimed my favorite quote on this he said far more money has been lost by investors preparing for Corrections or trying to anticipate Corrections than has been lost in Corrections themselves we should now have an understanding of the magnitude and dispersion of historical returns and the understanding that normal market returns are hard to define it is probably not reasonable to have expectations for any given year but that doesn't mean that we can't attempt to build expectations about the future expectations about the future are an extremely important part of the investing process we've talked about long-term risk premiums if anything it might be reasonable to believe that long-term risk premiums will persist in some form at least on a relative basis so that's things like stocks beating bonds we also know that there is information in prices research has shown that there is a relationship between current valuations and future returns where high valuations might mean lower future returns in a 2016 white paper titled great expectations my PWL capital colleagues Raymond ko0 and Dan were talati explained the process that PWL uses to estimate future returns for financial planning purposes first it is necessary to estimate inflation which can be done using the difference in yield between a 30-year government bond and a 30-year real return government bond that figure currently comes in at 1.7 percent next we look at the equilibrium cost of capital which is the 50-year historical real return of each asset class this gives us an idea of the historical equity risk premium but that figure may not be overly useful in estimating the future in a 2017 paper a swath de Motorin explained that equity risk premiums can change quickly and by large amounts even in mature equity markets consequently I have forsaken my practice of staying with a fixed equity risk premium former chair markets and I now vary it year to year and even on an entry year basis if conditions warrant as we might expect relying on the historical return is not a great way to think about the future current valuations are important to future returns to remedy this we use a second estimate derived from current yields based on the Shiller cape which is the current price over the ten-year trailing earnings adjusted for inflation if valuations are high the Cape will result in lower expectations for the future and if it is low they will increase our expectations as de Motorin mentions this method results in a much more volatile estimate for future returns these two methods of estimating expected returns each have shortcomings but they do complement each other well there is evidence that using current valuations gives a more reliable estimate but it also changes much more rapidly than the long term risk premium relying solely on valuations to estimate future returns with being a moving target in terms of how much you need to be saving to reach a financial goal or how much income you can sustainably be spending in retirement taking an average of these two estimates results in a figure that reflects current conditions but is also more stable due to the inclusion of the 50 year risk premium for a full walkthrough of how to estimate future returns I have linked Raymond and Dan's paper in the notes returns in any given year are unlikely to reflect anything that you might expect but having expectations is a very important part of investing taking care to make a reasonable estimate for future returns should be considered one of the most important parts of building a financial plan second only to completely ignoring those estimates when evaluating returns over a relatively short period of time how do you estimate future returns tell me about it in the comments thanks for watching my name is Ben Felix of pwl capital and this is common sense investing I will be talking about a new common sense investing topic every two weeks so subscribe and click the bell for updates [Music] [Music]

Channel: Ben Felix

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Keywords: common sense investing, ben felix, stock returns, stock returns average, variance of stock returns, standard deviation, stock returns average variance and standard deviation, stock returns regression, stock performance, wealth management, investment strategies, investment for beginners, investing, how to invest, stock market, financial advisor, normal stock returns, normal stock market returns, normal distribution stock returns, rational reminder, rational reminder podcast

Id: WhYHrHiOS_E

Length: 9min 37sec (577 seconds)

Published: Fri Oct 12 2018