The idea that stocks provide fairly predictable long-term returns is one of those fundamental beliefs upon which practically the entire investment industry is based. Lately however, I’ve seen a lot of people questioning the validity of that assumption.
And I can’t blame them. Having your portfolio decline in value by 40% in one year doesn’t exactly breed confidence in the value of holding stocks. Unfortunately, volatility is the price of admission.
However, even with the atrocious results of 2008, the (very) long-term return on stocks is still excellent. For example, for the 25 years ending 12/31/08, the market–as measured by the S&P 500–earned an effective annual return of 9.71%. Not bad.
Here’s the catch: In order to have earned that 9.7% return, you actually had to stay invested in the market throughout the 25 years even when the market was going down. Most people don’t do that.
If you bought and sold several times throughout the period, your return could very well be dramatically different from the 9.7% figure. It could be much better, or it most likely is much worse.
In short, if you jump in and out of the market, your long-term returns become much less predictable.
Looking Ahead
We can say with a fair amount of certainty that market returns for the next 30 years will be somewhere in the 7-10% range. (Based on the “Gordon Equation” of dividend yield + earnings growth, as explained in Bernstein’s Four Pillars of Investing and Bogle’s Little Book of Common Sense Investing.)
What we don’t know, however, is what the market’s going to do for 2009, 2010, or any particular year in the future.
If you want predictably decent returns, then buy an all-market index fund and never sell it. At least, don’t sell it until you’re retired and drawing down on your investments.
Want to take your chances at great returns? Then pick stocks. Jump in and out of the market or switch from fund to fund every year. Just make sure that you’re fully aware that with such a strategy is as likely to harm your return as help it.
About the author: Mike writes at The Oblivious Investor, where he reminds readers to ignore the day-to-day market news and focus instead on getting investment fundamentals right. Subscribe to his blog for daily updates.
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