A hypothetical investor hypothetically invested for entire 66 year span, “owning the market”, would have done pretty well. But what about typical investors? The relevant timespan for most investors is much shorter than 66 years. Few investors are heavily invested in the stock market for such a period. For many investors, a more relevant investing timespan is more like 5, 10, 20 or 30 years. These shorter time periods are important, because investors are often told by advisors (and I myself have been guilty of it) that a period of 5, 10 or 15 years is long enough to be considered long-term when it comes to investing. That’s important because it is assumed that long-term investing will bring high long-term returns. But as we’ll see, such time periods are not long enough to guarantee strong market returns. A stiff Bear market can easily wreck an investor’s 5-, 10-, or even 20-year investment plan, and the assumed return contained within it.
Let’s start by looking the 30 year period of 1950-1979. In the graph below, we see that it was not all smooth sailing for those earlier (hypothetical) investors. With this shorter perspective the inherent volatility is more visible than in the first graph. We also see on the graph, as I’ve highlighted, multiple 5-year and 10-year periods in which investors saw negative returns. For example, new investments in the stock market in much of 1965, and all of 1969 and 1973, would see negative 5-year returns, while those invested at any time in the years 1965 and 1968 would still be underwater 10 years later.
While the percentage of 5-year and 10-year losses was relatively low – a cumulative total of about 4 years out of 30 – there were much longer periods in which investors saw flat or very low returns. For example, those investing at any time in the last six years of the 1960s would see yearly average gains of no more than 3% per year over the following 10 years, far below the rates of inflation, which we’ll look at next.
The previous graph shows stock prices on a nominal basis. That is, not accounting for inflation. But one of the primary reasons that investors put money into the stock market is with the expectation that their money will stay ahead of inflation. Indeed, that is really the primary purpose of long-term investing, to guard against the loss of purchasing power. It is for that reason that investors endure the inherent volatility in the stock market over less volatile, but lower-earning assets. Inflation is the hurdle which investors and their investments must surpass to truly achieve the goal of long-term investing. But even for investors in the stock market, inflation enacts its slow and steady influence. Whether the stock market is booming, flat or falling, inflation has a profound impact on the potential for investors to earn a positive after-inflation return in the stock market.
To reflect ongoing inflation, the chart below shows the S&P 500 index for the same 30-year period, but reducing returns based on reported changes in inflation, based on the Consumer Price Index (CPI). We see that while the shape is similar to the prior graph, there is more downside. And instead of a few years of negative 5 and 10-year returns, we now see much larger blocks of time in which investors owning the market would not have achieved a positive investment return, after considering inflation.
Specifically, every investor owning the market from August 1964 until 1975 would have seen 5-year returns that did not keep up with inflation, as would every investor from September 1963 until the end of the decade would have seen negative after-inflation 10-year returns and every investor from April 1959-December 1965 would have seen negative 15-year negative real returns. It’s actually worse that this graph shows. Real, after-inflation, negative 10-year and 15-year returns would continue to be “earned” by investors buying all the way up until 1974, not achieving a positive after-inflation return until September 1984 and April 1989, respectively. This is the danger in assuming the stock market will always stay ahead of inflation over the “long run”, when the long run isn’t so long.
As far as more recent times, the story is a similar one. The graph below shows nominal (before-inflation) returns of the S&P 500 from 1980 to today. As the first stock market bubble of the period took hold in the late 1990s, investors at those times would see negative 5-year and 10-year returns over the following years, as would many 5-year holders buying in the mid-2000s.
Even at this point in 2016, with the big surge in the stock market over the past seven years, investment returns over these longer term periods have not been particularly high for investors, even before inflation is considered. As of April 2016, the 5-year average nominal return of the S&P 500 is 9.2%; over 10 years it’s 4.6%; and over 15 years the market has averaged 3.4% per year.
In the graph below, I’ve updated it to account for changes in inflation, or CPI. (While there is much controversy as to whether or not the CPI has been understated in recent years, even at the levels of “official” reported inflation, the results are still meaningful.) With this inflation-adjusted graph the occurence of negative 5-year and 10-year returns is expanded. That includes buyers from the 4-year period of March 1998 to March 2002 who would still be underwater a decade later after inflation is considered. It also includes most of the entire decade of 1998 to 2008, in which the buyers in only a two-year span – October 2001 to 2003, would see positive returns five years later.
I also want to note, that I am only highlighting here negative returns, which admittedly is not an extremely large percentage of the entire timespan analyzed here. However, I’m also not pointing out the many periods where investment returns, after-inflation or before, were minimal or effectively zero. Doing so, especially on an after-inflation basis, markedly increases the spectrum of returns that investors will find unsatisfactory.
To emphasize this last point, I’ll offer this last graph showing the 10-year return an investor would earn if he or she owned “the market”, the S&P 500, both before and after inflation, at any point within the 56 year span of 1950-2016. (Since the first 10-year result does not occur until 1960, that is the first point where 10-year performance is analyzed.) So for example, if I purchased the market in January of 1960, the graph would tell me that ten years later on January 1970, my yearly average return before-inflation would have been about 5% per year, and after-inflation would have been around 2% or 3%.
If we look just at the before-inflation numbers we see that the periods in which the market returned 10% a year for ten years was rather small. The generally 10%+returns for the first half decade of the 1960s would have been seen from buyers from the early 1950s, as the roughly 15-year period of the late 1980s to early 2000s rewarded investors of the prior decade. But while those 20 years or so delivered good returns for investors, many of the other 36 years did not. In fact, there are about as many years where the market would have delivered 10-year returns averaging less than 5% (before inflation) as those earning 10% or more.
Not coincidentally, those poor 10-year future returns tended to be during times after recent strong performance in the stock market. A booming stock market in the 1960s helped lead to poor returns in the 1970s, as did the stock market boom/bubble of the 1990s led to poor returns of the 2000s.
A similar pattern is seen with after-inflation returns. At times those returns have been very high, notably coinciding with the melt-up stock market bubble in the late 1990s. However, from a long-term perspective, those extremely high returns were short-lived and simply stole returns from the following periods. The negative after-inflation returns over substantial periods reminds us that buying into very expensive stock markets nearly guarantees that the following ten years will produce negative returns, or at least very low ones, after inflation is considered.
The 10% level of average market returns is important. For decades, many advisors have been telling investors that by investing in the stock market they should expect yearly average returns of about 10%. But such returns are simply not achieved, as I discussed in my book Let Your Money Grow, even over multi-decade periods, and certainly not over shorter periods. While the concept of “long-term” investing often includes periods as brief as 5 or 10 years, the reality is that such time periods are not anywhere near long enough to guarantee investors a strong average return, nor to eliminate the volatility of the stock market.
Although it may seem strange, someone planning to invest for only five or ten years in the stock market is engaged in a form of market timing. On a spectrum of investing on one end and speculation on the other, a 5 or 10-year investor is moving toward the speculation side of the scale. He or she is saying, “I know that the market is sometimes negative after 5 or 10 years on a before-inflation or (especially an) after-inflation basis, but I don’t think that will be the case this next 5 or 10 years”. But if that’s the case, that same investor should have a basis for thinking that way, preferably with knowledge of where current market valuations place it within the stock market cycle. When stock markets are expensive on a historical valuation perspective (as they are now), future intermediate-term (e.g., 10-year) returns tend be low. When the market has low valuations by historical standards, future returns are generally high. Not knowing the true state of the market can have a devastating impact on an investment portfolio that is planned for years, not decades.
It should also be pointed out that investors as a whole don’t earn market returns. Collectively they earn less than the market. There are two primary factors further limiting investment performance for the typical investor. One is the tendency for investors – professional and individual – to underperform the market, either because of chasing the market or specific industry sectors higher or selling after declines.
The second factor is the fees paid. Investors don’t get to participate in the stock market (and bond and other financial markets) for free. While mutual fund and other investment fees have (thankfully) come down over the past decade, they are still there, in the form of commissions, asset-based fees, fund management fees, administrative fees, account fees, trading expenses and others. While the range of fees various considerably among individuals and circumstances, total fees of 0.50% to 2.0% yearly of the amount of investment assets is very common. Some will pay less but many pay more. Even assuming just a 1.0% in yearly fees from stock-based investments, this further widens the gap between the market’s collective return and the return to the universe of investors.
With history and common sense as a guide, be extremely skeptical of advisors or websites suggesting that you should expect 10% or more average yearly investment returns. This ignores the fees an investor pays, as well as the mix of assets in an investment portfolio. And with cash and bonds paying next to nothing these days, investors cannot count on such assets to provide high returns as they often did in the past. In addition, there should be considerations of where we are the stock market cycle. Currently, because of the effects of government money printing on the financial markets, the current lofty valuations on Wall Street have borrowed returns from the future, to the detriment of today’s investors.
Even over the long-term and in bull markets, actual returns to investors tend to be modest. A study by John Bogle found that investors in U.S. stock mutual funds during the period of 1980-2005 returned an average of 7.3% per year. That sounds pretty good, but compare it to the stock market itself, which returned an average of 12.3% over the same period, comprising the greatest bull market (and stock bubble) in market history.
A 5% average yearly underperformance over a 25-year period should provide adequate evidence that the majority of investors will not match the market, even in the best of times. And given that objective valuation measures show that today’s stock markets are overvalued compared to historical averages, we should expect future intermediate-term (e.g., 10-year) returns to be below average. Today’s “long-term” investors planning to invest for just five or ten years, may find that realized returns weren’t what they were expecting. The stock market has historically delivered high returns over the truly long term, 30 years or more. Those investing today with shorter investment timespans need to be realistic with their expectations.