If you were planning a vacation to Dallas, Texas, you might hire a travel agent to give you tips that will help you pack appropriately. The agent might tell you that the average annual temperature in Dallas is 64 degrees. Guess what? It’s almost never 64 degrees in Dallas. It’s typically much hotter or much colder than that. The agent’s information is useless if you are coming during the summer, as you will not need to pack a light sweater. The same thing happens in the world of investing. Many financial advisors and financial models use long-term average returns to give investors an expectation for their portfolio returns. The problem with temperatures and investments is that you rarely get the average.
The Investment Horizon
Open almost any investing textbook, and it will tell you that stocks average about 10% per year. That’s true, but keep in mind that those numbers are averaged over at least 70 years. If your investing time horizon happens to be 70 years or longer, then you might be okay with the expectation of 10% returns, and you can stop reading at this point. But what can you expect with a shorter time horizon?
What are the odds that stocks will return 10% for a calendar year? Maybe 10% is too precise number to use for this analysis, but what about a range of 8-12% returns? From 1928-2016, the S&P 500 returned between 8-12% only 5 times. During that timeframe, the S&P 500 returned greater than 25% exactly 23 times and returns were negative 24 times. Based on historical probabilities, your odds of your portfolio growing around 10% on a yearly basis are, well, below average.
The often quoted 10% number is only an average over very long time horizons and rarely achieved by investors. This analysis did use one-year returns and you know stock returns smooth out after a few years, right? What about 10-year returns? Ed Easterling, founder of Crestmont Research, analyzed 10-year rolling returns since 1900 and found that the S&P 500 has returned between 8-12% just 20% of the time. The S&P 500 annual returns are greater than 12% about 36% of the time and less than 8% about 44% of the time. So, if you have a 10-year investing horizon, you have about a 1 in 5 chance of achieving your expected return.
Most investors have an overall time horizon of much less than 70 years, so they should not expect to achieve average returns.
If you don’t know what a proper expectation of your returns are based on your time horizon, talk to someone who does. We do and would love to discuss it with you. You can reach us at 214-922-9200 or www.mscm.net/contact-us.