Average annual returns are actually very rare

Here at RockWealth, we like to encourage our clients to think in terms of probabilities when trying to estimate what their future returns might be. So, for example, the average annual returns of a particular asset class over, say, the last 25 years, gives you at least a clue as to the sort of returns you can expect it to deliver over the next 25 years. But how common is it for equities to deliver average returns in any one calendar year? Well, the average annual return of the global stock market over the past 25 years is around 9%. Sounds pretty good, doesn’t it? But what if you were told that in two years in that quarter century, the market experienced losses of more than 20%? How do you feel now?

Average doesn't mean typical

A mental mistake that many individual investors make, when confronted by quotes about average annual returns for stocks, is to interpret the average return as the typical return. Yet we know that the reward for holding equities is not distributed evenly across time. Understanding and being prepared for the broad manifestation in stock market returns is a big part of learning how to exercise discipline in investment. Admittedly, this is not an easy skill to acquire. After all, while financial advisers quite rightly plead with their clients to maintain a long-term focus, the simple fact is that each of us experiences life day-to-day, moment-to-moment.

Seeing the big picture

There are a few techniques, however, for stretching our focus from today’s news and markets, however ugly, to the long-term returns we are seeking. One is to look at the distribution of returns on a chart. Below you can see the annual returns of global stocks going back a quarter of a century. As a measure, we’ve used the MSCI All Country IMI Index, net of dividends and denominated in pound sterling. The annual average for this period, of 9%, is shown as a grey dashed line. But notice that individual year returns were as strong in this period as nearly 35%, in 1999, and as weak as a loss of 25%, in 2002. In only two years over this quarter century, in 2004 and 2007, were stock returns within a percentage point of the average.

The breadth of the manifestation of market returns from year to year – the bumpiness of the ride, if you like – is the price we have to pay for getting to where we want to go. After all, if the road was smooth, and results were evenly distributed, there would be little risk to investing. And if there were no risk, there would be no return.

Diversification means a less bumpy ride

Of course, diversifying internationally results in a less bumpy ride than putting all your eggs in one country’s market. Ireland, for instance, had a particularly tough experience in the global financial crisis with its stock market down more than 60% in 2008. Three years later, it was the top performing developed market in the world with a return of nearly 15%. By spreading your portfolio across many markets, the extremes are lessened. And you can moderate the swings even further by spreading your risk from stocks-only to a portfolio that encompasses stocks and bonds. For instance, a 60/40 portfolio (that is 60% in global stocks and 40% in global bonds) over this same period would have cut those big down years by about half, while still delivering an average return for the full 25 years of around 7%. By the way, there is no one perfect asset allocation for everyone. The right mix of investments can depend on your age, circumstances, goals, risk appetite and a host of other factors. These things are best judged with the assistance of a professional adviser who knows your situation.

Summary

Earning the average long-term returns that the market offers requires an 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. The ‘average’ return publicised in the glossy pamphlets is just a mathematical construct. Rarely, as we have seen, does the market deliver an ‘average’ return from one year to the next. The return that counts for you is the one that matches your time horizon. In the meantime, ensuring your portfolio is as diversified as possible and adding a quantum of fixed income alongside the more volatile equities component can help smooth out the ride without significantly compromising returns.