Don’t expect the average

How often do you expect to experience your target return in any given year?

You probably heard that the stock market generates about 10% annual returns on average. Sounds pretty good, doesn’t it. From 1926 to 2020, the average return for the U.S. stock market was basically 10% per year. That’s a great average for a very large data series. But what if you don’t have 75 to 100 years to invest?

Is this 10% annual average a reasonable expectation for a person with a far shorter planning term, say 20 years?

Would it not be great if you could simply rely on this 10% return to be dutifully delivered every year? While that may be true in the long run, the market rarely delivers anything close to an average return in a given year.

We make the mistake to interpret the average return as the typical return.

Consider the chart below (Ritholtz Wealth Management). It plots the S&P 500’s annual returns since 1926.

Returns are widely distributed with no cluster around an average. It varies greatly from one year to the next. Returns are all over the place with no consistency. You cannot predict what will happen next year.

Our expectations have a huge impact on our experience.

When investors have a return expectation informed by a long average it could lead to unreasonable expectations and trigger behaviours that do not serve their long-term objectives. Investors need to be informed about the path dependency that is normal and to be expected from their investments.

What about local assets?

For the purpose of comparison, I have used the annualised return as the average that you would have experienced as an investor for the full period.

For the period 1996 to 2021 the FTSE JSE All Share (Total Return) Index Calendar Year Returns delivered an annualised return of 13,70%.

The black dotted line represents the annualised return for the period. In 26 calendar year returns the average was experienced only once (nearly) in 2003. For the rest of the period the calendar year returns either over-or-under shoot the average, at times by some margin. Bottom line – don’t expect the average every year. Returns are not evenly distributed.

What about bonds?

The equity market is more volatile than the bond market, so is it a reasonable expectation that investors could experience the average return with greater regularity with bonds?

Below is the calendar year return profile of the FTSE All Bond (Total Return) Index from 2001 to 2021:

The annualised return for this period was 9,87%. Although the average return was experienced nearly 4 times over these 21 years, it still represents less than 20% of the time. We see that the calendar year returns also over- and-under shoot the average.

Earning the average long-term returns that the market offers requires the ability to stay in your seat. Because we don’t know when the big up years will come, we have to sit through the down years. But over time, we’ll earn what the market offers.

Goal-based investing

The goal-based investing process usually results in a target return portfolio, for example inflation+4% (CPI+4%). When an advisor says, “you can expect this portfolio to make about 9% per year, over the long run,” the client only hears, “this portfolio will make 9% per year.” They do not intuitively understand that the return will over-and undershoot on the way to the desired average over a reasonable time frame. That this is an expected average over the long-term, not to be measured annually.

When markets are booming advisors are on the red carpet for not beating the markets. When markets tank, the same clients ask why they aren’t more diversified and protected against losses.

If client expectations are not addressed and set realistically at the outset, it will cause uncomfortable conversations later for all the wrong reasons. Advisors need to educate and continuously remind clients what to expect on the path to harvesting long-term returns. You can’t sell performance without talking about risk.

One of the biggest challenges that advisors face when working with their clients is properly setting and managing expectations for portfolio returns. The average historic long-term returns as an expectation is the one goal that you are ensured to not hit with any sort of consistency.

Sources

• https://www.evidenceinvestor.com/an-average-return-year-is-rarer-than-you-may-think/

The above article was written by Marius Kilian.