The Range of Possible Outcomes You Must Know
One of the reasons many investors fail to earn market rates of return is their lack of understanding of the relationship between risk and return.
A simple way to view this is that every investment carries an expected return. When evaluating any investment, the risk of that investment is measured by the degree its returns deviate from the average return during specific periods of time. For example, if an investment averaged a return of 8% per year over a 20-year period, how far up and down did prices move over that period to arrive at that average return? Was it ever up or down 40% at any point, or only 12%?
Higher risk (or more volatile) investments carry a wider range of short-term outcomes, but may also carry higher expected long-term returns, which compensate investors for withstanding short-term volatility.
In contrast, investments that have experienced a narrow range of outcomes over long periods of time are expected to provide more consistent returns with the trade-off of lower returns.
You can think of higher-expected returns as the reward (the premium) for an investor’s willingness to accept higher volatility on some of their investment holdings.
Historical Perspective
Once you have earmarked and allocated sufficient funds to support multiple years of future withdrawals in fixed-income instruments, an ingredient to help outpace inflation and maintain your purchasing power is your strategy for accepting and managing higher volatility. Your investment portfolio can help capture the historical risk premium of owning broadly diversified stocks.
Effectively carrying out this strategy requires historical perspective on the range of possible outcomes in any given year, and what you will interpret as normal during future short-term market corrections vs. the “this time is different” noise generated in the financial media.
Here are four of my favorite graphics from Dimensional Fund Advisors to help provide the necessary historical perspective. Simply click each title to view the graphic:
1.The Bumpy Road to the Market’s Long-Term Average: As this chart illustrates, using the S&P 500 Index for measurement, the U.S. stock market has rewarded investors with an annualized return since 1926 of about 10% per year. However:
- Annual returns came within 2% of that long-term average only six times during those 98 years.
- Yearly returns have ranged as high as up 54% and as low down as 43%.
2. U.S. Market Intra-Year Gains and Declines vs. Calendar Year Returns: This graphic uses the Russell 3000 Index (largest 3000 U.S. Companies) and illustrates the range of returns during each year from 1979 through 2023. Here are some takeaways:
- The long lines illustrate the range of “intra-year” returns, i.e. in 1987, market prices were down about 30% at one point and up almost 40% at another point.
- The large dots represent where the Russell 3000 Index finished the year. For example, in 1987, the total return ended the year just above zero. You may recall that market prices fell more than 22% percent on Black Monday October 19,1987, yet prices fully recovered by the end of the year.
3. A History of Market Ups and Downs: This graphic illustrates all S&P 500 Index downturns of 20% or more from 1926 through 2023, the number of months they lasted, and the associated cumulative performance for each market period. Note the average duration of each bear and bull market.
4. Distribution of U.S. Market Returns: This last graphic illustrates the annual returns from 1926 through 2023 of the CRSP 1-10 Index which measures the performance of the total U.S. stock market. Here are some takeaways:
- Returns were positive in 74% of the years, and negative in 26%.
- 10 of those years finished with a return ranging from 0% to negative 10%, while 16 years finished between 0% and positive 10%.
- Three of those years finished with a return ranging from negative 20% to negative 30%, while 23 years finished between positive 20% and positive 30%.
Potentially capturing higher-expective returns to help protect your future purchasing power requires strategy, discipline, and historical perspective of the range of possible outcomes. I recommend keeping these four graphics close by at all times to reference, especially during normal and historically temporary market corrections.
Retirement Countdown Guidebook
When you’re about five years away from retirement and have at least $500,000 saved, it may be time to start the final approach. We have spent over 30 years helping guide people into retirement and distilled that collective wisdom in this guidebook.
This is intended for informational purposes only and should not be construed as personalized investment advice.
Past performance is no guarantee of future results. Historical performance results for investment indices, benchmarks, and/or categories have been provided for general informational/comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results.
Jack Phelps
Managing Partner / Financial Advisor