“Invest for the long haul. Don’t get too greedy and don’t get too scared.”
Shelby M.C. Davis
[Originally published March 2022, and updated Feb 2023 to include FY2022 data]
Do stock prices always go up? Obviously not, as we found out in 2022. However, stocks do go up in the long run, recognising that exactly what “long run” means is open for interpretation. In other words, stock prices certainly do not go up every single year, but the longer the time horizon, the more likely total returns on stocks are to be positive.
To give you a sense of this, the compound average annual growth rate (“CAGR”)[1] of large cap stocks in the US since 1926 has been 10.1%[2], and the standard deviation over the same period has been 19.8%. This means that returns on stocks can vary sharply from year to year. Taking inflation into account, stocks have generated on average a real total return of 7.2%/annum since 1926. Coming back to volatility and to give you a sense of year-to-year returns, the range of annual returns (nominal) since 1926 for US Large Cap stocks has been from a low of -43.3% in 1931 to a high of 54.0% in 1933. Looking at a more contemporary period starting in 1950, total returns on stocks have ranged from a low of -37.0% in 2009 to a high of 52.6% in 1952. Because of the high year-to-year volatility, returns on stocks should be evaluated over long periods of time.
Stocks in a portfolio
The amount that you should allocate to stocks in your portfolio depends on your personal risk profile, which in turn is often dependent on the stage of life in which you find yourself. The allocation of your portfolio to stocks should involve money that is not needed in the short- or intermediate-term given the volatility of the asset class year to year. Stocks are an asset class that should be held alongside other asset classes like bonds, real estate, precious metals and alternative assets. Perhaps most importantly, your portfolio should also include enough cash or cash equivalents so that you can pay expenses for six to 12 months without having to liquidate stocks – or any other asset class for that matter – during difficult periods. None of this is revolutionary advice – it is “personal finance 101” – but it is important for me to mention this before speaking specifically about long-term returns on equities.
The data set
For the work I have done in this article, I used total return data from 1926 to 2022 for “Large Cap Stocks” – essentially the S&P 500 – provided by Morningstar Direct and Ibbotson Associates. This analysis is based on total annual returns, consisting of three components: capital appreciation (or depreciation), dividends, and the reinvestment of dividends as they are received. I looked at this data over three periods:
1926-2022 (96 years), the entire period for which data is available;
1950 to 2022 (72 years), which excludes the Great Depression and WWII, both highly volatile and rather unusual periods for stocks (and markets generally); and
1985 to 2022 (37 years), which excludes the Great Depression, WWII, and the the high inflationary period of the late 1970s / early 1980s.
Nominal and real returns on stocks over time
The table below shows compound average annual returns (nominal and real) and the standard deviations for each of the three periods I described in the section above.
As you can see in this table, real returns have actually improved and volatility has lessened over the more recent (and shorter) periods of time, perhaps reflecting a better understanding by both the government and Federal Reserve as to how to use fiscal and monetary policy, respectively, to influence economic cycles, especially to soften downturns. On the other hand, there could be an argument that returns over the more recent (higher return) periods will eventually drift towards the average return for the longer (i.e. 96-year) period of time. Only time will tell, but the main point of this table is to show that nominal and real returns of equities over very long periods have been attractive. According to “A Wealth of Common Sense”, US equities have on average returned 400-500bps more each year that the 10-year US Treasury. The table below from Blackrock (here) contains a broader array of asset classes and is more contemporary (through early 2023) but has data only since 2014. Even so, the advantage of holding US equities vis-à-vis other asset classes (and equities in other parts of the world) over this period is clear, as you can see in the right-most column in the table below.
The holding period
Although returns on stocks can vary sharply from year-to-year, ranging from highly negative to highly positive, returns are more likely to be positive the longer the holding period. The table below illustrates this reality for two of the periods I used earlier – the entire 96 year holding period (since 1926), and the 72 year period, starting in 1950, which excludes the Great Recession and WWII. Returns are summarised on an annual basis (1-year column) and are also presented over rolling periods of three-, five- and 10-years[3]. For example, over the 96-year period, I looked at the 10-year average annual return for stocks over 86 periods, meaning the 10 years ended 1935, then the 10 years ended 1936, and so on, until 1922. The results of this analysis are in the table below
As you can see in the table, the longer the holding period, the fewer the number of periods that stocks were negative over that period. This is true for both the full 96-year period and for the period since 1950. For example, whereas annual returns (i.e. the one-year column) were negative 26.8% of the time between 1926 and 2022, they were only negative 4.6% of the time over 10-year rolling periods for the same timeframe. The fact is that the longer your time horizon, the less likely you are to have a negative return on your stock portfolio. Perhaps more interesting is that returns have only been negative in two consecutive years on three occasions since 1950: 1973-74; 2000-01 and 2001-02[4]
Of course, I am fully aware that the investment time horizon for investors – especially since the pandemic – has almost certainly gotten shorter, bolstered by unprecedented amounts of pandemic-related stimulus. Impressive total (nominal) returns of stocks of 31.5%, 18.4% and 28.7% for 2019, 2020 and 2021, respectively, inspired investors to pile into equities on the basis that “stocks go up every year”, but 2022 was a stark reminder to investors that equities can be highly volatile and that returns can most certainly be negative.
The most important thing you can do as an existing (or for that matter prospective) investor in the stock market is to do a “gut check” and make sure you can emotionally withstand periods of high volatility and downturns, which can last weeks, months or even years, not just days. The “buy the dip” mentality that became so prominent during the pandemic, lost steam in 2022. However, it feels that positive returns in the first few weeks of 2023 might be drawing momentum investors back into stocks as equities power forward.
Timing the market / “day trading”
The final thing I wanted to speak about is market timing. All investors, including this one, believe that they have a knack for knowing when equities will rise and fall. About the only real truth one can espouse though brings us right back to my opening assertions in this article – over the long-run, stocks go up. If you fancy your ability to time markets, let me illustrate the good news and the bad news, referring to the table below.
Looking at these tables, note that:
The compound average annual growth rate (nominal) of equities since the beginning of 1950 has been 11.2%/annum, meaning that your investment at the beginning of 1950 would have increased 2,389x over this 72-year period!
Had you been out of the market for the five best years during this run (1954, 1958, 1995, 1975 and 1997), your CAGR over the same 72-year period would have been reduced to 8.7%/annum, meaning that your initial investment would have increased only 434x by 2022 (18% of the amount had you stayed invested the entire period).
Had you been so savvy to avoid the five-worst years during this period (2008, 1974, 2002, 2022 and 1973), your CAGR over the period would have been 13.4%/annum, meaning your initial sum in 1950 would have increased 9,475x by 2022 (397% of the amount had you stayed invested the entire period). Is anyone able to predict the downturns though on a consistent basis? Absolutely not!
In fact, unless you have a near prophetic ability to call the highs and lows, the best thing is to stay invested rather than trying to time the market, embracing strategies like dollar-cost averaging and reinvestment of dividends. This doesn’t mean you should be completely passive, but rather should fine tune your holdings / allocation from time to time to get in front of economic, company or macro / secular trends. If you have the urge to trade, then segregate a small portion of your portfolio to trade actively “on the side”, but do not get it confused with a core portfolio of equities whether individual names, mutual funds or ETFs.
[1] This and all other stock data referenced in this article is from Ibbotson® SBBI® US Large-Cap Stocks (Total Return) data, which has stock returns dating back to 1926. It is available to CFAs on the CFA website. According to the descriptive summary edition from 2021, the data I am using throughout this article is essentially the S&P 500. “Total returns” for this index include three components: capital appreciation, dividends, and the reinvestment of dividends. You can find “Stocks, Bonds, Bills & Inflation (SSBI): 2021 Summary Edition” here. [2] The annual return is nominal, meaning it is not adjusted for inflation, and is calculated on a compound annual growth rate basis. For reference, the arithmetic average is 12.0%/annum over the same period. [3] The three-, five- and 10-year periods are calculated using compound average growth rates. [4] Note that the consecutive 2-year periods of 2000-01 and 2001-02 mean that stock returns were negative for three consecutive years, from 2000 to 2002.
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