Every piece of collateral advertising an investment product reads, “Past performance is not guarantee of future results.” Yet, evidence of investors chasing performance clearly illustrates that warning is lost on most investors. In fact, following our natural instincts leads us to apply faulty reasoning to investing. We believe that the market’s most recent performance is what we can expect.
To guide clients on the subject of expected rates of return, we analyzed the returns of the S&P 500 Index from 1926 through 2015 (90 years) and prepared the graph below of how often the S&P 500 fell Index between various 10% intervals.
You will note that 21.1% of the time the S&P 500 generated a return between 10% and 20%. During this 90-year period of time the average return of all 90 years (not the compound annual return) was 11.95%. However, an investor rarely received an 11.95% rate of return. Looking at the data more closely, you would see that only 15.6% of the time the S&P 500 delivered a return that was between 6.95% and 16.95%, i.e., 11.95% plus or minus 5%. (Note 4.4%, 7.8%, 8.9% and 11.1% of the time it fell within plus or minus 1%, 2%, 3% or 4%, respectively.)
You will see the same results looking at the annual returns of various asset allocations. Most of the time, annual returns deviate significantly from the long-term, historic returns. Many investors figure there is something wrong when that happens. Investors need to understand that those long-term returns are delivered to the patient, disciplined investment. The chart below from Dimensional Fund Advisors’ illustrates that idea most clearly: Successful investors exercise discipline to look beyond today’s hot stocks and beyond last year’s returns to the growth potential of the market over the long term.