Why You Shouldn't Base an Investing Strategy on a One-Year Return

June 23, 2015

Most people don’t like to see short term fluctuations in the value of their retirement savings account. When the value of the account goes down, they think they will never have enough money to retire. When the value goes up, they think they have ample savings and cut back on their contributions only to find that they have short changed themselves later. The fluctuations most of the time are caused by the ups and downs of the stock market. Over a short period of time the stock market returns can jump or down, and people have a natural tendency to project the recent experience well into the future.

The varying nature of returns

Let’s look at the experience of someone who started investing in stocks twenty years ago. Say that in 1995 this person started his career and put some money in a broad market stock fund that mirrored the S&P 500 index. In the first year they earned a 22.6% return. That was followed by three more great years when they earned 33%, 28% and 21% respectively. At that point the investor thought investing was easy.

The following year in 2000, the tables turned in a biblical way and the investor experienced three bad years. The returns on the S&P index for 2000, 2001, and 2002 were -9%, -11%, and -22% respectively. Now the investor thinks that only bad things can happen and they better get out while they still can. Would that have been a good choice?

The high cost of running scared

The middle part of the decade turned out to be a great time to be investing in stocks. From 2003 through 2007 the investor experienced five good years with three of those posting nice, double-digit returns. The bad year came in 2008 when the housing crisis and the start of the financial recession dropped the value of stocks by 37%. These were dark days for investors and many people sold out their decimated holdings thinking that stocks would continue to decline in value. They could not have been more wrong. Since 2008 we have experienced six straight years of positive returns. In 2009, the S&P 500 index bounced back at 26% and all of the lost value was recovered by 2012.

So where did that leave this twenty-year investor? Over the many ups and downs, from when things looked fantastic to when things looked very bleak, the gains more than offset the losses. The cumulative gain over the twenty years was 368%. The compounded annual return was a respectable 6.75%. If the investor had ignored the short-term ups and downs and held to their long-term goals, then they would have fared very nicely.

What does that mean for the average investor?

Looking at a single year of stock market returns doesn’t give you a very good idea of what to expect in the future. The individual years can be extremely variable. People often make the mistake of extrapolating recent returns into the future when it's far better to observe a longer time period and expect to experience some bumps along the way.