Understanding Stock Market Returns: A Closer Look at the 10% Figure
When it comes to investing, a prevalent belief circulating among many is that stocks will yield an average annual return of 10% or more. However, this notion is misleading and can lead to detrimental financial decisions. As articulated by Ben Felix, a portfolio manager at PWL Capital, it's essential to dissect where this figure originates from and why it may not be a reliable estimate for expected returns.
The commonly cited 10% annual return stems from historical data, particularly from the performance of US stocks between 1950 and 2023. During this timeframe, US stocks delivered a nominal annualized return of 11.32%. However, when considered over the last 20 years, the total US market’s return was only a 9.81% annualized.
Nonetheless, the essence of this figure lies in the distinction between nominal and real returns. While nominal returns are the percentage increases in market value, they do not account for inflation, which ultimately affects purchasing power. The real returns provide a more accurate representation of an investment's performance post-inflation.
Taking a closer look at the data, the real return on US stocks from 1950 to 2023 sits at approximately 7.63%. Even over the past 20 years, the real return drops slightly to 7.16%. These figures highlight that while 7% real returns are commendable, they still contrast sharply with the aspirational 10% figure often quoted.
A significant factor contributing to the inflated nominal returns over the past decades has been rising stock valuations. Since 1950, the dramatic increase in these valuations has skewed investors' expectations, leading to the assumption that such trends will persist indefinitely.
The relevance of historical performance in shaping future expectations cannot be overstated. The work of researchers Eugene Fama and Ken French reflects this sentiment, recognizing that while the averages of past returns can inform predictions, they may not reliably forecast future performance.
Analysis indicates that the substantial returns between 1950 to 2000 were primarily driven by rising valuations, which are unlikely to be repeated. High valuations often suggest that future expected returns will be lower rather than higher—an aspect often overlooked by optimistic investors.
The equity premium puzzle presents a more complex challenge. Historically, US stock returns have often exceeded predictions made by economic models. Studies have indicated that factors like good fortune—where significant economic disasters have bypassed the US—contributed to this anomaly as well.
Current research concludes that the real return on US stocks, adjusted for luck and learning, is closer to 5.28%. This figure aligns more closely with pre-1950 data and countering expectations set by recent trends.
When analyzing global returns, the data reveals a slightly tempered perspective on stock performance. Excluding the US market, global real stock returns from 1900 to 2023 hover around 4.35% to 5.16%. Even when accounting for US stocks, researchers project a median expected return of around 5.28%.
These findings suggest that the commonly cited 10% return—which translates to a real return of approximately 7%—is notably higher than rational estimates based on the historical performance of both US and global stocks.
Conclusion: A Pragmatic Approach to Expected Returns
At PWL Capital, the emphasis is on employing data-driven expectations for stock returns in financial planning and wealth management. Using historical global returns while factoring in current market valuations leads to a more credible expected return of approximately 4.62% real, or 7.24% nominal, assuming 2.5% inflation.
The implications of assuming a 10% return are substantial. Differences in expected returns can significantly affect retirement planning, savings, and overall investment strategy.
Ultimately, it’s crucial to recognize that while stocks remain a superior investment compared to bonds, the expected returns are not as high as commonly believed. A realistic approach that considers both historical data and prevailing market conditions is essential for sound financial decision-making.
In summary, embracing a pragmatic perspective on expected stock returns can empower investors to make smarter choices, ensuring better financial health and effective retirement planning.
Part 1/8:
Understanding Stock Market Returns: A Closer Look at the 10% Figure
When it comes to investing, a prevalent belief circulating among many is that stocks will yield an average annual return of 10% or more. However, this notion is misleading and can lead to detrimental financial decisions. As articulated by Ben Felix, a portfolio manager at PWL Capital, it's essential to dissect where this figure originates from and why it may not be a reliable estimate for expected returns.
The Origin of the 10% Figure
Part 2/8:
The commonly cited 10% annual return stems from historical data, particularly from the performance of US stocks between 1950 and 2023. During this timeframe, US stocks delivered a nominal annualized return of 11.32%. However, when considered over the last 20 years, the total US market’s return was only a 9.81% annualized.
Nonetheless, the essence of this figure lies in the distinction between nominal and real returns. While nominal returns are the percentage increases in market value, they do not account for inflation, which ultimately affects purchasing power. The real returns provide a more accurate representation of an investment's performance post-inflation.
Real Returns vs. Nominal Returns
Part 3/8:
Taking a closer look at the data, the real return on US stocks from 1950 to 2023 sits at approximately 7.63%. Even over the past 20 years, the real return drops slightly to 7.16%. These figures highlight that while 7% real returns are commendable, they still contrast sharply with the aspirational 10% figure often quoted.
A significant factor contributing to the inflated nominal returns over the past decades has been rising stock valuations. Since 1950, the dramatic increase in these valuations has skewed investors' expectations, leading to the assumption that such trends will persist indefinitely.
Contextual Considerations
Part 4/8:
The relevance of historical performance in shaping future expectations cannot be overstated. The work of researchers Eugene Fama and Ken French reflects this sentiment, recognizing that while the averages of past returns can inform predictions, they may not reliably forecast future performance.
Analysis indicates that the substantial returns between 1950 to 2000 were primarily driven by rising valuations, which are unlikely to be repeated. High valuations often suggest that future expected returns will be lower rather than higher—an aspect often overlooked by optimistic investors.
The Equity Premium Puzzle
Part 5/8:
The equity premium puzzle presents a more complex challenge. Historically, US stock returns have often exceeded predictions made by economic models. Studies have indicated that factors like good fortune—where significant economic disasters have bypassed the US—contributed to this anomaly as well.
Current research concludes that the real return on US stocks, adjusted for luck and learning, is closer to 5.28%. This figure aligns more closely with pre-1950 data and countering expectations set by recent trends.
Global Context and Expected Returns
Part 6/8:
When analyzing global returns, the data reveals a slightly tempered perspective on stock performance. Excluding the US market, global real stock returns from 1900 to 2023 hover around 4.35% to 5.16%. Even when accounting for US stocks, researchers project a median expected return of around 5.28%.
These findings suggest that the commonly cited 10% return—which translates to a real return of approximately 7%—is notably higher than rational estimates based on the historical performance of both US and global stocks.
Conclusion: A Pragmatic Approach to Expected Returns
Part 7/8:
At PWL Capital, the emphasis is on employing data-driven expectations for stock returns in financial planning and wealth management. Using historical global returns while factoring in current market valuations leads to a more credible expected return of approximately 4.62% real, or 7.24% nominal, assuming 2.5% inflation.
The implications of assuming a 10% return are substantial. Differences in expected returns can significantly affect retirement planning, savings, and overall investment strategy.
Part 8/8:
Ultimately, it’s crucial to recognize that while stocks remain a superior investment compared to bonds, the expected returns are not as high as commonly believed. A realistic approach that considers both historical data and prevailing market conditions is essential for sound financial decision-making.
In summary, embracing a pragmatic perspective on expected stock returns can empower investors to make smarter choices, ensuring better financial health and effective retirement planning.