Why are my annual returns so far from average?
The true investor welcomes volatility ... a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses.
—Warren Buffett
If you had invested in a diversified portfolio of global stocks in 1976 and held it all the way to today, you would have received a compounded annual return of around 8.5% (in SGD). (The simple annual average return would have been 10.8%.)
However, only 5 out of those past 44 years saw annual returns within two percentage points of that 8.5%. The returns for the other years were often wildly different. Some years produced sky-high returns as high as 45%. Others suffered massive losses as low as negative 43%. Most other years were somewhere in-between.
It's a common mistake for investors to assume that average return rates can be expected every year. After all, that's usually the case for the interest rate we receive from bank deposits. This misconception can cause investors to be disillusioned if a given year (or a few consecutive years) produces a return far below that annual average.
In such times, it can help to step back and take a look at the bigger picture. Average return rates already take those low or negative years into account. Since 1976, investors experienced 9 negative years out of 44 – which means a positive outcome 80% of the time.
Source: GYC, Fama/French Indices
Market downturns are thus only to be expected. The good news is what happens next.
If we use the longest dataset possible – a broad US market index tracking data from 1926 – we can see that stocks have tended to deliver very positive equity returns in the one-year, three-year and five-year periods following steep declines.
The effect is especially striking when we consider cumulative returns. Five years after sharp market declines of 10%, 20% and 30%, compounded returns all topped 50%. Viewed in annualized terms across the longest five-year period, those returns were close to the historical annualized average of 9.6% for the entire period.
In other words, it's in those few years after a market decline that investors see the bulk of their returns – right after many of them have sold out in panic.
Such behaviour is to be expected. Hitting a bumpy patch can set off a lot of fears and anxieties about when and if the market will recover. Why shouldn't you wait until things are clearer before putting your money back to work? Unfortunately, this more often than not means you'll be left waiting on the sidelines with cash in hand when the markets suddenly shoot back up.
A lot of research has shown that missing the best days of the market can be extremely detrimental to your annual returns. The chart below illustrates just how bad this can be.
The road to investment success is not straight. Neither is it smooth. You may experience long periods where your returns don't look anywhere close to their historical or projected average, but this doesn't mean the numbers are wrong. As the evidence shows, it's much more unusual for annual returns to be close to their average.
As long as your portfolio is well diversified, you can find comfort in knowing that investors can always expect higher returns following a bear market. March this year was an example of that. Panicking and selling at the wrong time will only hurt your long-term returns. Conversely, waiting it out will let you experience the good times that follow the bad. This is one reason that patient investors are rewarded.
Keep this wider perspective in view, and you'll find it easier to stick with your investment plan and ride out the inevitable ups and downs. The road may not be straight, but it will get you to your destination in the end.
