Probably one of the hardest things individuals have to grasp is the variability of investment returns. When someone has a bank account there is a stated interest rate, so there is a comfort factor, in that you know what kind of return you are receiving. With the stock market the level of uncertainty is much higher.
Surveys have shown the expectations of returns for the stock market can vary wildly among various individual investors. Some people think there is an equal likelihood of making money versus losing money in the stock market, while others may think a return of 20% a year is reasonable.
Even among investment managers there is uncertainty about what to expect stock market returns to be. However, the questions asked for professional investors normally relate to their opinion of stock market returns for the next year, not the long term average.
In essence the key is to differentiate between the expected return for the stock market for one year versus what it may average over 10 years. Among professional investment managers there would be significant variability in their expectations for one year, with less variance for their forecasts of average annual returns over 10 years.
Among individual investors there tends to be less differentiation about expectations of what investment returns might average over the short run versus the long run. Essentially some individual investors might think the likelihood of losing money in the stock market is about the same for one year, as it is for 10 years.
For example the likelihood of having a down year in the stock market is about 20%. However, over 10 years the probability of losing money, and that would reflect also the contribution of dividends, is less than 5%.
This same thought process could be used for people investing in real estate. In our local market over the past several decades prices have tended to rise as much as 20% in good years, and have fallen 10% in bad years. However, if someone looks at what real estate returns have averaged on a rolling 10 year basis the dispersion of returns would be a lot less.
What the real estate investor should do like the stock market investor is focus on the expected long term averages. Looking too much at what is occurring at the present time can cloud someone’s judgement of what their long term expectations should be.
Investors should also realize that there will still be some variability in 10 year returns. While the stock market has averaged close to 10% annual rates of return going back many decades, not every 10 year period has generated close to those levels of increases.
Likewise the last two 10 year periods of real estate returns in out local area have given significantly different returns. Someone who bought a property in 1996 when prices were down, and sold in 2006 at the peak would have done extremely well. The period from 2006 through 2016 would not have seen, as good of returns. Actually in some areas of Los Angeles County prices have yet to surpass their 2006 levels.
People should recognize that if an investment is made in the stock market after several years of above average returns the likelihood of achieving high returns in the future tends to lessen. For example someone investing in the stock market at the present time should not necessarily think that he/she will be averaging 10% annual returns over the next decade.
This is not to imply that someone should not be investing in the stock market at the present time, but that one’s expectations should be lessened. It should also be noted that the long term averages included periods where inflation and economic growth were greater than what we are experiencing at the present time.
Therefore, annual return expectations of 6 to 8% over the next 10 years for the stock market might be more reasonable than the long term average of 10%. Given where interest rates are, a 6% return is still significantly better than what someone would earn from a bank account, or investing in the bond market.
What investors need to remember is that in the short run there will be significant variability in stock market performance. However, the longer one invests the closer to the long term averages one’s annual returns will be, and having a long term perspective is essential for those investing in the stock market.