Year On Year - How Annual Returns Vary Over 27 Years

We all want to be prepared for the future, investing is part of our preparation. When making our plans, we typically have expectations of what reward we should receive for the risks we take. But share performance is inherently uncertain, so how can we plan ahead?

Let's look at the year-by-year performance and try to gain some insights.

An Uncommon Average

How often is any given year an average year?

When investing in shares, the range of outcomes for a single year is large. Each year is rarely close to the average. To illustrate this, we used the calendar year returns from 1992 - 2018 (27 years) for a portfolio of shares. We used long-term benchmarks for our current portfolio models.

The average annual return for this period was 9.9%. But of the 27 years, only 5 were within +/-2% of this average (between 7.9% and 11.9%). This means more than 80% of outcomes were 2% above or below the average. The following graph shows the returns for each year.

For a balanced portfolio, with 60% shares and 40% bonds, the average return was 8.2%. We can see the range of returns is narrower, but still only 5 out of 27 years fall between 2% above or below the average.

Time is Your Friend

The range of returns narrows over time

We expect returns will get closer to the average over time. Within the time frame above, we can look at the best and worst returns over a variety of time periods. Below is a graph of the range of returns over 1 year, 3 years, 5 years and 10 years for our portfolio of shares.

For the balanced portfolio, the ranges are narrower. Again there is a less uncertainty over time.

Long-term Perspectives

Accepting year-to-year volatility for long-term results

While we use long-term averages to plan for the future, we also accept short-term returns seldom fall close to these averages. Years of poor performance are a part of investment as much as years of strong performance. Looking at performance over longer time frames, the results speak for themselves.

Performance of Premiums

As both investment markets and our recommended funds have been volatile lately, we thought it would be useful to describe how portfolios are built and how they perform.

The following only scratches the surface, but covers the decisions which drive the majority of returns.

Asset Allocation

Asset allocation is what you invest in and where. The split between growth assets like shares and defensive assets like cash or bonds is the most important decision.

In the investment world, risk = returns. More specifically, risk = long-term returns. While including more shares in your portfolio increases the average return, the value will also fluctuate much more. After all, in any given year, shares typically do be better than cash about 60 - 70% of the time. Over time the odds improve; the charts below show the frequency shares outperform cash in four different markets, over 1-year, 5-year and 10-year periods.

We can see the trade-off between risk and return below. There are five hypothetical portfolios, each split between cash (S&P/NZX 90-Day Bank Bill Index) and NZ shares (S&P/NZX 50 Index). The more shares, the higher the return but the bigger the drops.

The countries you invest in make a large difference in short-term returns. For example, from 1997 - 2000, a poor manager buying US shares would probably earn you more money than a good manager buying NZ shares. For the following 3 years, the poor manager in NZ would do better! This is why we must evaluate each manager against the relevant benchmark. Below is a chart showing performance of NZ, US, Australian, European and UK shares respectively.

Investment Strategy

Once we have decided on what and where, next is how. Within each market, how do we pick the companies themselves?

You could choose an active manager, who claims to pick the best companies and avoid the worst, while charging a fortune for the service. However, research by Standard and Poors shows how these managers have done poorly for their clients. Below is the percentage of managers who underperformed the markets they trade in.

Another option is index funds, a cheap way to invest in the markets where active managers have failed. This is clearly (as shown above) a better option, but we can do better. In standard index funds, companies are arranged and purchased based on their size. But we can rearrange how capital is invested to tilt towards areas of higher returns without resorting to stock-picking or limiting diversification. We tilt towards dimensions of higher expected returns.

We mentioned how shares don't always outperform cash. The same applies to these dimensions; small companies don't outperform large companies each year, but the odds increase over time. The charts below show the frequency with which small companies outperform and, below that, value companies.

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Like shares, there are times when these "premiums" are negative. Long-term, the results speak for themselves.

Sharks in the Water

It wouldn’t be the start of beach season without the papers’ nearly daily headlines of a shark attack or sighting. As soon as we think about getting in the water, sightings start making headlines. Yet we still venture in to the water, knowing the risks and enjoying the rewards.

Much like shark headlines, financial markets have been getting a fair (or unfair depending how you look at it) share of column inches. Yes, world markets are down from where they were in late September, and yes it could be down even more by the time you read this……..but we knew this could happen, in fact we need it to happen. Much like swimming at the beach, we invest our money understanding the risk but enjoying the rewards.

No one knew how the market would perform this year. No one knows how the market will perform next year. No one knows if stocks will be higher or lower. Indeed, even though the probabilities favour a positive outcome, no one knows if stocks will be higher or lower in 5 years.

We DO know that, according to Forbes, “since 1945…there have been 77 market drops between 5% and 10%...and 27 corrections between 10% and 20%” We know that market corrections are a feature, not a bug, required to get good long-term performance. A single dollar invested in the US market in January 1945 would have grown to $2,658 (!) by the start of December (S&P 500 index).

We do know that during these corrections, there will be a host of “experts” in the paper, on business TV, blogs, magazines, podcasts and radio warning investors that THIS is the big one. That stocks are heading dramatically lower, and that they should get out now, while they still can. Yet we survived the GFC, Dot Com Bubble, 1987 Crash and other seemingly catastrophic events.

We know that given the way we are wired, many investors will react emotionally and heed these warnings and sell their holdings, saying they will “wait until the smoke clears” before they return to the market. This often leads investors to forget the #1 rule of investing “buy low, sell high”.

We know that over time, most of these investors will not return to the market until well after the bottom, usually when stocks have already dramatically increased in value.

We know that, no matter how much stocks drop, they will always come back and make new highs. That’s been the story since the late 1700s.

We know that this cycle will likely repeat itself, with variations, for the rest of our days, and probably many following.

While it is understandable to be wary of sharks in the water, we know the risks are low and keep diving in. While it is understandable to be anxious about drops in the market, keep perspective, stick to a plan and consider the long-term outcomes.

So instead of reading the headlines about things you can’t control, why not tune out the noise, focus on what you can control and enjoy Christmas secure in the knowledge that we’ve seen these things before and have always made it out the other side.

Merry Christmas from all of us at Strategic Wealth Management