“Financial advisers need to show their clients what the distributions of stock returns are over time.” This paraphrased recommendation was given by University of Chicago professor Eugene Fama at a CFA Chicago Society event held last week. The comment was in reference to what happens to returns the longer an investor remains allocated to stocks.
Fama was specifically referencing the historical distribution of returns—a bell curve. For those of you less familiar with statistics, a bell curve plots out a group of data. Think of it as a valley followed by a hill followed another valley. To the extent data points are within a normal range, they are bunched up, forming a hill (the “bell”). The valleys are the outlying low (“left tail”) and high (“right tail”) values.
We’re working on annotated bell curves of equity returns to show graphically how their variances change over time. While the charts are not ready for prime time, the takeaway from them can be explained. In simple, summarized terms: The longer an exposure to stocks has been maintained, the more likely positive outcomes occurred and the closer the outlying returns were to the typical range. Put another way, if you look at your portfolio with the frequency Rip Van Winkle would, you’ll more likely notice both gains and less volatility.
An equal-weighted portfolio of the largest 30% of exchange-listed stocks averaged a 12.5% annual return between 1927 and 2016, based on data from Kenneth French’s website. The worst return was -47.1% (1931), while the largest return was 74.9% (1933). There were 11 years when losses exceeded 10% (seven in excess of 20%) and 31 years when gains exceed 20% (17 in excess of 30%)—a lot of variance.
If we extend the period to five years, the variance of returns narrows. Annualized returns averaged 10.5%. The worst return was -16.4% (1928-1932), while the largest return was 28.1% (1932-1936). There were three five-year periods where losses exceeded 10% and eight five-year-periods when returns exceeded 20%. As you can see, the variance is less and the left tail has moved rightward (towards the 0% mark).
Going out to 10 years, the variance is even less and the odds of having made money greatly improved. The worst return was -1.0% (technically -0.95% between 1928 and 1937), while the largest return was 18.7% (1949-1958). There were only two 10-year periods when annualized were negative (1928-1937 and 1929-1938). Again, the left tail continued to move right, while the overall range of returns was even smaller.
This data tells you a few things. First, the less you look at your portfolio’s performance, the less volatile your equity allocation will seem. Second, the odds of realizing a positive return greatly improve with time. Third, the risk of a loss does not fully go away, though the magnitude of any loss shrinks with time. Combined, the data favors a long-term commitment to equities along with less frustration about the day-to-day, month-to-month or even year-to-year returns.
- Data Mixed on Whether Volatility is Rising – When volatility is looked at on a monthly—instead of on a daily—basis, there is no clear evidence that it has risen over the past 80 years.
- The Role of REITs for Long-Term Investors – It’s not just the perceived return of stocks that changes over time, so does the performance of real estate investment trusts as this 2012 AAII Journal article explains.
- Improving on the Magic Formula – A change in how profitability is calculated was shown to realize higher monthly returns than Joel Greenblatt's original formula.
- Long-Term Care Insurance: Less Benefit for the Premium – The duration of policies has declined and the growth in daily benefit coverage has lagged the growth in premiums.
Twelve S&P 500 companies are scheduled to report, including Dow component Nike (NKE) on Thursday.
The week’s first economic reports will be May durable goods orders, which will be released on Monday. Tuesday will feature the April S&P/Case-Shiller home price index and the Conference Board’s June consumer confidence survey. May international trade in goods and May pending home sales will be released on Wednesday. Thursday will feature the final revisions to first-quarter GDP. May personal income and spending, the June Chicago purchasing managers’ index and the University of Michigan’s final June consumer sentiment survey will be released on Friday.
Four Federal Reserve officials will make public appearances: San Francisco president John Williams on Monday, Tuesday and Wednesday; Philadelphia president Patrick Harker and Minneapolis president Neel Kashkari on Tuesday; and St. Louis president James Bullard on Thursday.
The Treasury Department will auction $26 billion of two-year notes on Monday, $34 billion of five-year notes on Tuesday and $13 billion of two-year floating rate notes and $28 billion of seven-year notes on Wednesday.
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A modest decrease in the percentage of individual investors who expect stock prices to decline sent pessimism to a four-month low. Bearish sentiment, however, remains close to its historical average in the latest AAII Sentiment Survey. Additionally, this week’s survey shows small increases in optimism and neutral sentiment.
Bullish sentiment, expectations that stock prices will rise over the next six months, rose 0.4 percentage points to 32.7%. Optimism is below its historical average of 38.5% for the 17th consecutive week and the 22nd time out of the last 23 weeks.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose by a mere 0.2 percentage points to 38.4%. This is both the eighth consecutive week and the 13th out of the last 14 weeks with a neutral sentiment reading above its historical average of 31.0%.
Bearish sentiment, expectations that stock prices will fall over the next six months, declined 0.6 percentage points to 28.9%. Pessimism was lower on February 15, 2017 (27.7%). Bearish sentiment has been slightly below its historical average of 30.5% during six out of the last seven weeks.
Record highs for the S&P 500 and the NASDAQ have encouraged some individual investors, but the Trump administration’s ability (or lack thereof) to move forward on economic and tax policy remains on the forefront of many others’ minds. Also, playing a role in influencing sentiment are earnings, valuations, concerns about the possibility of a pullback in stock prices and interest rates/monetary policy.
This week’s special question asked AAII members how this year’s rate hikes and the Federal Reserve’s intention to further tighten monetary policy are impacting their market outlook. Slightly more than half of all respondents (51%) said the hikes are either having no impact or only a minimal impact on their outlook. Several of these respondents said the gradual removal of stimulus was already factored into the market. About 22% thought the rate hikes were a positive sign, primarily because they reflect improving economic conditions. Approximately 11% of respondents had the opposite view and think the rate hikes could be bad for stocks. Many of them expressed concerns about a forthcoming pullback in stock prices.
Here is a sampling of the responses:
- “The markets have already priced in rates hikes; no change in my market outlook.”
- “Makes me more bullish. The Fed is showing confidence in the economy.”
- “I believe the anticipated Fed’s moves will have a neutral effect on the market. Political impacts...who knows?!”
- “Rate hikes and overbought equities make me think a correction is coming.”
Bullish: 32.7%, up 0.4 points
Neutral: 38.4%, up 0.2 points
Bearish: 28.9%, down 0.6 points
Local Chapter Meetings
June 16, 2017 Is It Active or Passive?
June 8, 2017 Invest, Exceed Goal, Then Stop Taking Risk
June 1, 2017 Dividends and Buybacks Drive Stock Returns
May 25, 2017 My Notes From the CFA Institute’s Annual Conference