As measured by the S&P 500, large-cap domestic stocks have produced an annualized return of 9.8% since 1926, or 6.8% on a real basis (for the period ending 12/31/2011; Source: Ibbotson and Standard and Poor’s Index: SBBI S&P 500 Index). Decent numbers to be sure, but the average hides a lot of history. When it comes to performance, indexes, like individual portfolios, are a collection of uneven events.
Breaking that 85-year stretch into just two periods, for example—from 1926 to 1981 when interest rates peaked, and from 1982 to 2011—we get very different outcomes. For the period 1926 until the beginning of 1982, the S&P produced a gain of 6.1% real terms. In the declining rate environment from 1982 to 2011, however, the real return for large-cap stocks jumped to 8.0%. Breaking down performance even further, say, by the decade, the numbers swing even wider.
Seeing the numbers raises an interesting question: How often do the returns by decade match the long-term average? Answer: Never. On a real basis, the only decade for the S&P that was even come close to the long-term average was the 1960s, and then there was a 150 basis point differential. Fact is, the performance of large-cap stocks by the decade bears little resemblance to the long-term average. The same is true if we look at small-cap stocks, long-term government bonds or long-term corporate bonds. Which raises another question: Does any of this matter?
Actually it does, and a lot. That’s because many investment advisors and financial planners use historic long-term returns for their forward-looking return expectations. Using historic numbers in either the asset allocation process or arriving at wealth and spending forecasts introduces two major problems.
First, there is no fundamental reason why stocks should provide anything close to their long-term returns in any given decade. And yet investors undoubtedly view any 10-year period as “the long run.” We would suggest that the misalignment of expectations and reality rarely leads to happy clients.
Second, the extrapolation of past returns--damaging enough in the realm of equities—can often be downright reckless for investment-grade fixed income, as is the case right now. At this point in the cycle, a 30-plus year of declining interest rates virtually ensures that the past won’t be prologue. The average real returns produced by long-term government bonds since 1982—an astoundingly high 8.2% according to Ibbotson and Barclays Capital—will not be duplicated anytime soon. Nor will the nearly-as-astounding 7.7% produced by long-term corporate bonds.
If advisors and financial planners utilize these abnormally high historical returns to make wealth and spending forecasts,
‘When’ Really Matters
So if short-term market timing is imprudent (and we know it is), and relying on long-term averages to play out is irresponsible, what, then, is an investor to do? We believe that advisors, first and foremost, must acknowledge that the investment starting point matters greatly. While metrics like equity valuations, interest rate levels, and corporate bond spreads can be highly predictive of future rates of return, we have to remember that those metrics can and do change dramatically over short periods of time.
In practice, we know that when the equity market is priced cheaply, future returns will likely be in excess of the long-term average, and vice versa. But we also know that the equity market can remain cheap (or expensive) for extended periods of time. Cheap valuations don’t ensure strong returns over one-, three-, or five-year time periods, but they do increase the probability of above-average returns over time.
In our opinion, the best course of action is to take more risk when the likelihood of an above-average payout increases and take less risk when the reverse is true. Others attribute different meanings to it, but this is what we refer to as dynamic asset allocation. With this approach, we think advisors increase the probability of achieving positive investment outcomes over time for their clients. It’s the best way we know to lessen the chance of a material funding gap during retirement.
Author’s disclaimer: The views and opinions expressed are provided for general information only and do not constitute specific investment advice or recommendations from the author.