Stocks: How do you estimate expected returns?

September 29, 2015

The returns from investing can be very volatile even in the safest investments. Unlike depositing your money in a bank and getting a predictable interest amount, the returns on your investment accounts can go up and down in what seems like an unpredictable manor.

How can you make sense of this and what can you expect from your stock market investments?

Let’s take a look at stocks. The value of a stock is the amount someone will pay you to buy it.

What they will pay is determined by two factors:

First, stocks reflect ownership of companies and the owners get the profits that companies can earn. If the profits are up from the stocks, people are willing to pay you more to own the company. If profits are down, people will not be willing to pay as much.

Secondly, the stock values reflect the expectations of the direction of future profits. These expectations can be very fickle and often reflect recent experiences. When the economy is rosy and profits are going up, investors tend to overestimate the values of stocks and pay too much. Conversely when storm clouds appear and profits fall, investors get too pessimistic and underestimate the chances of a recovery and sell at too low a price.

The stock market is cyclical and the valuations swing from too optimistic to too pessimistic with human emotions.

Look what has happened to stock market values in past cycles. In 1990, the US economy slipped into a recession and the S&P 500 stock index had a price decline of 6.6 percent. If you adopted a pessimistic attitude and sold your equity investments, you would have missed a recovery in 1991 that took stock prices up 26.3 percent.

The opposite occurred at the end of that decade when stocks were up by 20 and 30 percent for five consecutive years. The optimism faded in the “dot com” crash and widespread pessimism followed with three years of 10 and 20 percent declines. The cycle repeated itself in the 2000’s with five years of price gains ending with the housing market meltdown in 2008 and a 39 percent decline in the S&P Index.

That sharp decline scared many investors away from stocks. Looking at the one-year drop caused many investors to underestimate the potential returns in stocks and miss a recovery that lasted seven consecutive years. Clearly, taking the most recent returns and projecting them into the future has been formula to either over or underestimate stock returns.

The better way to estimate potential returns would be to look at a longer period over several cycles.

Looking at the chart above, if we look at the entire period from 2000 to 2015 we can see that the average price return for the S&P 500 index was 8.9 percent. Does this mean that the index returned 8.9 percent every year? Of course it doesn’t. Some years, like in 2008 where the index declined 38.5 percent, were exceptionally bad. Some years, like 1995 where the index increased 34.1 percent, were exceptionally good. Clearly the experiences over a short period of time can vary greatly but taken over a longer period of time the average one-year return was very reasonable.

When you are looking at your investments, you are looking at potential returns over a long period of time. Stock market investments are volatile and any one-year return can swing from positive to negative. Basing your expectations on recent experience can lead you to be too optimistic at the top of cycles and too pessimist at the bottom of cycles. For realistic results, your expectations of what your stock market investments will earn should be based on an average return across several cycles.