The consistency of stock market returns: Why market corrections are a feature, not a bug
Stock markets have been volatile so far in 2018, grabbing headlines and investors’ attention. Based on their news commentary, the financial media seems to believe the stock market exists to deliver reliable, positive returns year after year. When the market doesn’t provide positive returns in a particular year, the media and even investors start to think something must be “wrong.” The error these investors and the media make is not recognizing that positive returns only come as an average return over time — not every year.
Since the stock market must either go up or down, you may think stock market returns are a 50-50, gain-loss proposition. However, you may be surprised to learn that since 1926, the S&P 500 Index, which is made up of the 500 largest U.S. stocks, has been positive roughly 75 percent of calendar years; only about 25 percent of those years have produced a loss. Obviously, if an investor could avoid owning stocks in the negative years, their return would be even higher than if they used a buy-and-hold approach. With this in mind, some investors attempt to time their investments in stocks, but almost every study has concluded that trying to time the market is futile for the vast majority of investors, as it often leads to underperformance.
Yet, despite all the evidence that stocks are the highest-returning asset class over the long term and that almost nobody can time the market consistently, investors and the financial media usually treat market corrections as an abnormal occurrence. In fact, market corrections — sometimes severe corrections — are a feature of successful long-term investing, not a “bug” in the system that needs to be fixed. If investors understood and accepted this fact about the markets, they may likely be less emotional about downturns and make better long-term decisions.
Since 1928, U.S. stocks have produced an average annual return of about 10 percent, while, for comparison, U.S. Treasury bonds have returned a little more than 5 percent. However, during that time period, U.S. stock returns have ranged from -43.5 percent in 1931 to 56.7 percent in 1933. Those one-time extremes mask the fact that during this historical time period, only 10 years produced worse than -11 percent annual returns, while 53 calendar years provided positive returns over 11 percent. Considering the historical data, let’s make an assumption that the ratio of positive years to negative years and rates of return are likely to stay somewhat consistent going forward — those would be great odds for investment success over time. Here’s another way to consider the probability of success: Would you knowingly accept 10 years of losses of 11 percent or more, in exchange for 53 years of positive returns over 11 percent? I think most people would gladly take that bargain. Stock market returns are never guaranteed, and no one is able to consistently predict how the market will behave in the future. However, the arguments above are strong indicators that markets tend to reward a disciplined investor over time.
Long-term investors in stocks have been well-rewarded for accepting the risk of short-term losses compared to the gains they could achieve in cash or bonds. It’s important for investors to understand they are getting “paid” for the uncertainty of year-to-year returns through the higher, long-term returns that stocks provide compared to “safer” assets like U.S. Treasury bonds or cash. However, in order to accept the higher stock returns, it’s also important for investors to accept the roughly 25 percent of calendar-year declines as a normal aspect of the way stock markets work, not as a problem they must solve — as painful as those times may be. This is the unforgiving link between risk and return — an investor can’t achieve higher expected returns in stocks without taking the associated risk of potential year-to-year stock market declines.
Even if investors understand that stock market returns should be favorable over time, most of them simply can’t stomach the volatility and occasional, significant market declines that come with solely investing in stocks. As a result, there are some portfolio strategies that help mitigate some of this year-to-year stock market risk, and they can even boost returns. For example, bonds can help stabilize a portfolio and reduce the volatility and risk associated with stocks. In addition, strategic rebalancing from time to time can ensure that no one segment of the portfolio becomes outsized, creating unnecessary risk. Finally, taking advantage of occasional losses through tax-loss harvesting can provide additional benefit on an after-tax basis.
Dean T. Stange, JD, CFP, is a principal and senior financial advisor at Wipfli Financial Advisors LLC.
Click here to sign up for the free IB ezine — your twice-weekly resource for local business news, analysis, voices, and the names you need to know. If you are not already a subscriber to In Business magazine, be sure to sign up for our monthly print edition here.