No financial planner can know what the future will bring, and none should pretend to. Markets, stock prices and ultimately return are all beyond anyone’s calculation or control. Any plan that reacts to market events is a plan that is doomed to fail, so a successful investor must appreciate that markets are unpredictable and accept short-term deviations from long-term expectations.
However, in designing a plan we must also use reasonable assumptions to help determine what is realistic; not to attempt to predict the future, but rather to inform our long-term decision making. A key component is the expected return of a particular investment.
What Do We Mean By Expected Return On Investment?
When we talk about returns, we almost always reference an “average expected return,” or what you might expect if you averaged out the annual returns over a long period of time. We use history as our guide here, looking back through the ups and downs of the stock and bond markets to illustrate not only what is realistic, but how it comes to fruition.
Average Return Over Time: Don’t Miss The Forest For The Trees
The average expected return can be incredibly misleading if you allow it to drive your day-to-day or even year-to-year expectations. Think of it like this: if you flip a coin and receive $1 for heads and $0 for tails, your average expected return so far is $0.50 (the sum of the weighted probability of each result). If you flip the coin once, do you therefore expect to get $0.50? Of course not, you’ll either receive $0 or $1; you will never actually receive a $0.50 payout. However, after flipping 100 times, you can expect your average payout per flip to be somewhere around $0.50 despite the moment-to-moment experience being drastically different. The more flips you have, the closer your average should be to the statistical average.
Expected Returns and Standard Deviation
Short-term investment returns are much the same; they are incredibly variable, even when we look at them over 5 or 10 year time periods. You can’t gain a meaningful picture of return without speaking to standard deviation. Standard Deviation is a way to measure how much we expect the returns to deviate from the stated average. Statistically speaking, we expect returns to fall within one standard deviation of the median return 68% of the time, within 2 standard deviations 95% of the time, and to almost always fall within 3 standard deviations.
To put it more succinctly, in any given year there is a 50% chance your actual return will be worse than the long-run average.
If I have an average expected return of 5% and a standard deviation of 7%, I would expect my return to be between 12% and -2% the majority of the time (two thirds of the time to be slightly more precise). That doesn’t mean it will never be outside that range. In fact about 1 out of every 3 years should have returns outside that range, both positively and negatively. That’s one out of every three years! You must also be aware that in no way, shape, or form do previous down years impact the “likelihood” of future years being up. That’s known as the gambler’s fallacy (“I’ve been getting terrible cards; I must be due for good ones next hand!”).
If my average return is expected to be 7% with a standard deviation of 15%, it is just as likely that I have a negative 8% return as a positive 22% return over the course of the next year. If I have a negative 12% return, does that mean that our average expected return was wrong? No – statistically it’s right in-line with what standard deviation tells us is likely.
Now you can begin to see why short term returns are usually so much different than what we estimate on average. Especially when you consider that the S&P 500 Index has a 10-year arithmetic mean return of 7.72% with a 10-year standard deviation of 14.72% (as of this writing). So on average, a composite of the largest US companies returned anywhere between 51.88% and -36.44% in any given year (as of August 2015). Apple Inc. (AAPL), one of the largest, most popular companies around, had a 10-year standard deviation of 33.33% and its worst one-year return was negative 71.06%! That’s a huge variation in returns, even though the average return was quite good over the last 10 years.
Even returns outside of three standard deviations are possible, especially with individual company stock. Since the standard deviation is a historical measure, it is not a guarantee that future returns will remain within its boundaries.
Applying Averages To Your Investment Plan
The reason we must speak to averages and standard deviation is because it is the only sensible way to get some approximation of what to plan around moving forward. The year-to-year returns will most likely look nothing like the “average,” just like the coin flipping example above. There will be years where we are up 20% and years where we are down 20% – and that’s perfectly normal. I want that to really sink in.
Learn To “Expect” Some Losses
There will be years where your portfolio is going to lose a significant amount of money. History illustrates that fact quite clearly. But history also shows that those who stay disciplined and maintain their investments through these downturns always come out ahead, especially if they rebalance their portfolio periodically. The “average” return is largely driven by big market movements, both positively and negatively. Without the ability to predict the future, you need to stay fully invested to capture the average return.
However, most investors find this very difficult in practice because they anchor their short-term expectations to a long-term average. Even a few percentage point loss causes many investors to question their long-term plan, despite the fact that those returns are exactly in line with reasonable expectations.
How Can You Stay Out Of Trouble?
At Financial Plan, we diversify our portfolios to reduce the variation in returns while still maintaining the average expected return. However, an important consideration with a well-diversified, pragmatic portfolio is that there will always be a stock, a fund, a sector, or a market that is outperforming the portfolio. Always. That’s the nature of diversification. The point is that no one knows in advance what will be the next performer; the pragmatic approach, then, is to capture the entire market returns in an intelligent, efficient manner.
What’s The Bottom Line?
So what does this mean for you, the investor? Your primary goal in investing is likely very simple: success. And as history has shown time and time again, one of the primary determinants of success is how you react where your returns are below what you expect them to be. View average returns for what they are: not day-to-day or year-to-year guarantees, but rather approximations around which your actual return will fluctuate. Only then will you be prepared for the reality of investing and poised to succeed.
-Nathan Twining, CFP®