Most financial plans are based upon an expected return; some forecast of how we think the future may play out. As the years’ pass, we evaluate these returns to make sure we stay on track with the plans we set for ourselves. Now, as investors, we are always eager to know how much we will earn each and every year and so the conversation of returns is always front and center. I figured this was a good point to step back and look at how markets have reacted in years past and realistically how we should plan for future returns.
I recently listened to a conversation between Ken Fisher and Meb Faber. The interview covered a lot of Ken’s history, how he started Fisher Investments and his general outlook on financial markets. Something Ken mentioned during one of the segments was that the markets tend to trade in extreme ranges more often then they trade in line with long-term annualized returns. So simply put, it’s more likely the market will be flat, extremely positive, or negative than actually run into some 0-10% range.
I thought this was an interesting fact given that most financial plans are run using an assumed rate of return. If the stock market is so “sporadic” in nature, how can we stick to our plans when we are handed a mixed bag of returns each and every year?
Let’s start by looking at what Ken is actually referring to:
Above, you will find the annual returns for the S&P 500 dating back to 1988. As you can see, there have only been 3 years with stock market returns even close to 5%:
- 2007 – S&P 500 up 5.49%
- 2005 – S&P 500 up 4.91%
- 1992 – S&P 500 up 7.62%
Taking this a bit further, almost every year the stock market has returned something wildly different than our assumed “average annual returns.” Most investors use somewhere between 4-6% as an expected portfolio return but in reality, the markets rarely trade in these ranges.
If we break the stock markets returns into buckets, we can further understand the trends. Since 1928, the S&P 500 has traded in the following ranges (Source: Aswath Damodaran):
- Number of Years with Negative Returns: 24
- Number of Years with Returns of 1% – 10%: 15
- Number of Years with Returns greater than 10%: 51
Out of a sampling of 90 years of historical market returns, 83% of the returns could be considered an extreme return and only 17% of the returns fall between 1-10%.
So what does this mean for investors?
It is completely normal for markets to provide investors with out-sized, flat returns or even negative returns. Your investments don’t always need to be adjusted following a year that did not perform in line with your expectations.
Markets are inevitably irrational and the volatility from year to year should be expected. If your investing mindset is to simply hit 4-6% annual returns each and every year, you need to re-adjust your thinking, not your investments. These ranges are longer-term average annual return estimates and not expectations for each and every year.
Source: Carl Richards via Twitter
Second, avoid recency bias.
I named my blog similarly as a joke but seriously don’t let last years results dictate this year’s actions. Maintaining an investment strategy over time has more benefit to the success of your portfolio than trying to chase the top performing investment or strategy each and every year. If you can stay vigilant during a year of negative or flat performance, your portfolio will thank you in the long run.
Lastly, actually make a plan for your investments.
What returns do you actually need? Most people have no idea what they want their portfolio to do. Instead, they spent all their time chasing after whatever returned the most from the prior year and say “I want that!”.
As analysts run the numbers to determine the opportunity of an investment, so should investors to determine their personal required rate of return. Simply establishing a basic financial plan will really help determine what returns you should shoot for and how to allocate your own money.