Just about every day somebody asks me what I think the market is going to do for the rest of the year, or over the next quarter – or even the next week. I’m not qualified to make that kind of prediction and I don’t think it’s very useful. But I am often asked a more interesting and useful question: "What is a reasonable rate of return that I can expect on my investments over a long period of time?"

Obviously this question has many answers, which can be boiled down to one: It depends. It depends on how much risk you take, what kinds of investments you choose and how good your timing is – even if you are a buy-and-hold investor. And, of course, it depends on how much patience you have. If you’re a quick in-and-out trader, there’s no way to predict your return. But if you’re in the market for the long haul, you can look at history and get some idea of what to expect. Here, we’re going to do exactly that. And some of what we find may surprise you.

If you ask a reasonably informed person what return you can expect on stocks as represented by the S&P 500 Index, you’re likely to hear a number around 10 percent. On average, that’s what the S&P 500 has returned over the years. But sometimes, averages are nothing more than lies masquerading as statistics. Place one foot in a tub of ice water and the other in a tub of scalding water and on average you are quite comfortable. In reality, you’re in great pain.

Below, you’ll see a table showing some investment returns over 61, 10-year periods. This data is artificial in the sense that it assumes an investor plunked down a sum of money on January 1 of one year, left it alone and then sold the whole pot exactly one decade later. Even though real people seldom invest that way, this data is very interesting. It’s published by Ibbotson Associates and is based on historical returns of large company stocks (the equivalent of the S&P 500), small company stocks and long-term government bonds. All the figures assume a buy-and-hold strategy, without market timing.

The numbers in the table show compound annual returns for every 10-year holding period starting with 1926-35 through 1986-95. The fourth column shows the compound rate of returns after inflation for each 10-year period. Before we talk about the numbers, let me point out something that should be obvious: the decades shown in this table represent a lot of overlap. For instance, the period 1940-49 is 90 percent the same as the period 1941-1950, even though the returns of large company stocks during those periods were quite different (9.17 percent vs. 13.38 percent). That suggests that some significant difference occurred in either the year that was discarded for the second period (1940) or the year that was added for the second period (1950) – or perhaps in both. But these were not two completely separate 10-year periods.

In the second column, showing large company stock returns, you’ll see figures that range from a low of -0.89 percent (in 1929-38) to a high of 20.06 (in 1949-58). The average of all those 61, 10-year returns was 10.7 percent. But you certainly couldn’t count on getting that. In fact, there were only two decades when the returns were between 10 and 11 percent (1959-68 and 1974-83).

THERE’S NO GOOD ANSWER

Now imagine that a good friend asks you what investment return is reasonable to expect for a buy-and-hold investor with a 10-year time frame. What would you tell your friend? As well-meaning as you are, you’re really left without a good answer. How do you know that the next 10 years will be one way or the other? Statistically, they could be as bad as 1929-38 or as good as 1949-58. Chances are they’ll be in between those numbers. But they could be higher or lower than anything we’ve experienced since 1926.

Probably the best answer you can give your friend is that stocks have a long history of usually generating positive returns and over a long period of time those returns average around 10 to 11 percent if measured over a decade. But tell your friend not to put too much weight in an average. In 61 rolling 10-year periods, not one was exactly average! The decades 1974-83 and 1956-65 were close. But neither was exactly average. Of the 61 periods, 30 returned more than 10 percent, 30 returned less than 10 percent and one returned precisely 10 percent.

There are many interesting ways to evaluate this data and I’d like to share a few of my observations with you. The second column in the table shows that investors in large company stocks went through a long dry spell during the periods starting in 1960 and ending in 1982. Not one of those decades achieved a double-digit return. Try to tell those investors about long-term averages! On the other hand, we had 16, 10-year periods in a row with double-digit returns starting in 1941 and running through 1965. And 1974 was the start of another "run" of double-digit decades, 13 so far, without interruption through 1995.

WHAT DOES THIS MEAN?

If you believe history repeats itself in precise patterns, you could conclude that we have three more years to go before we equal the 1941-1965 run – and that we are "due" after that to slide into a long period of single-digit returns. That may seem vaguely plausible. But I just don’t think the market works that way. I don’t pretend to thoroughly understand the market, but I’m sure it is not driven by statistical patterns of theoretical 10-year returns.

But there’s something that’s just as important to investors as market returns – and that’s inflation. As the third column in the table shows, 10-year periods of inflation have varied all over the map, from -2.57 percent (that’s annual deflation, which most of us have never experienced) in 1926-35 to 8.67 percent in 1973-82. The average compound inflation over a decade was 3.61 percent. No period hit that exactly but 1985-94 came awfully close at 3.58 percent. In that same period, large company stocks gained an above-average 14.4 percent (remember we are talking compound annual rates).

LET’S GET REAL

After adjusting for inflation, investors were left with a real return of 10.82 percent. The real return, stated in constant dollars, is probably the most important measure of performance. If you calculate that figure for each of these 61 decades, you’ll find that these "real" returns varied from a discouraging -3.96 percent in 1965-74 to a spine-tingling 18.2 percent in 1949-58.

The bad news is that in seven of these periods, over 10 percent of the periods, large company investors experienced negative after-inflation returns. Those investors may have thought they were making money. They may have been taxed as if they were making money. But in reality, they lost purchasing power. Another 14 of the 61 decades had after-inflation returns that were positive but less than 5 percent. Those periods gave investors a real return for the risks they were taking, but not very much. The most recent one of those periods was 1974-83, when 10 years of inflation averaging 8.16 percent wiped out most of the 10.61 percent annual gain of large company stocks.

SOME GOOD NEWS

The good news is that the majority of decades, 40 out of 61, produced after-inflation returns of 5 percent or more – and 22 of them left investors with more than 10 percent after inflation. The most recent of those periods was 1986-95. For investors fortunate enough to cash in on one of these periods, it is considered a great return.

When investors commit money to stocks for a decade, they take real risks. The outcome is uncertain and they could easily lose money. And although the chart does not show it, long-term investors are always subject to sharp market swings that can wipe out months of gains in a day or two. In return for taking those risks, I think investors have a right to expect some compensation. And one of the best ways of measuring that compensation is the after-inflation return.

In all of these 10-year periods, the average return of large company stocks was 10.7 percent. Although inflation varied enormously, it averaged 3.61 percent over these periods, producing an average after-inflation return of 7.09 percent. That figure may not seem very impressive. But over 10 years, that will approximately double your purchasing power. What does that mean in real terms? In theory, it means that if you set aside enough money to take care of your family for one year and invested that money in large company stocks, a decade later you would have enough money to take care of your family at the same standard of living for two years. Though these figures are only history, and they’re only averages, I think they make a strong case that investing in large company stocks over an extended period of time is likely to be worthwhile.

I think there’s something else important here that might be easy to over look. These after-inflation returns demonstrate the profound effects that inflation can have on investment performance. No matter what you think of Alan Greenspan and the Federal Reserve, this table may give you a renewed respect for the importance of inflation.

SMALL COMPANY STOCKS

Before we leave this table of 10-year returns, I’d like to point to a couple of other things. In recent years, small company stocks have seemed to be all the rage. The results on the table show that in 47 of the 61, 10-year periods, from 1926 through 1995, small company stocks had double-digit returns. And in 11 of those decades, small company returns were over 20 percent. If you were trying to sell a small company stock fund, these figures would seem to make your case. But as you can see, the most recent decade in which small company stocks outperformed their large company brethren started in 1979 and ended in 1988. In every decade since then, large companies have done better than small companies.

This is particularly interesting because many advisors (and sales people) are hammering us with the notion that they should expect higher returns from small company stocks. Most of the emphasis on small company investing has come in the past few years. Small company funds are relatively easy to sell to optimistic investors. They do spectacularly well in bull markets. But they are also extremely vulnerable to bear markets.

FIXED INCOME RETURNS

Many investors prefer long-term government bonds to equities, and during the most recent eight 10-year periods represented in this table, those bonds produced double-digit returns, which peaked at 15.56 percent in 1982-91. Some statisticians might look at this table and conclude we have reached some new era for fixed-income investing. In fact, since 1979, long-term government bonds held for 10-year periods have performed better than small company stocks held for the same periods.

But to view double-digit bond returns as "normal" is to completely ignore the previous 53 decades. Not once in all that time were 10-year returns in double-digits for long-term governments – or long-term corporate issues for that matter.

What can a student of investing conclude from all this? If you looked back only as far as 1979, you could conclude we are in a "golden age" of investing with low inflation and double-digit returns on government bonds, small company stocks and large company stocks.

DRAWING CONCLUSIONS

I think it’s safe to conclude from this table that the future is uncertain and that over long periods of time equities have solidly outperformed bonds. We cannot know that this pattern will continue, but there’s no reason to think equities are likely to take a back seat to fixed-income investments.

Something else stands out for me in these numbers. As painful as the market dips of 1987 and 1990 were, those corrections didn’t derail the results of long-term investors. Instead, what really ruins a period is two successive bad years. This table shows nine successive periods that include the years 1973 and 1974. Those decades span 17 years, from 1965 to 1982, and not one of them produced large company returns of even 8.5 percent; indeed, only one exceeded 6.7 percent. I think the lesson is clear: Really severe market corrections come around every so often, and investors who are not prepared for them can find their results are impacted for decades.

Despite all the negative chatter about market timing, this table shows that when you enter and leave the market makes a huge difference. Unfortunately, you can only invest in the future, not the past. And you will find out later how good your timing was. While we’d all like to sign up for after-inflation returns in the double digits, reality tells us we can’t necessarily expect them – and we would be foolish to count on them.

I am not an investment doctor. But I can recommend five prescriptions – none of them original – that should improve your investment returns. Without reservation, I suggest you spend less, save more, diversify your investments, use market timing – and perhaps most important, do your best to enjoy life every day that you have. Today is a day you’ll have only once.

 

 

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