Waiting for Return
How long must I wait for an average return?
Common investment knowledge dictates that a “long run” time horizon is 5 – 10 years. But what does this mean, really?
We often talk about not investing anything in stocks that will be required to meet your cash flow needs within 10 years. The rationale for this is that historically stocks have hardly ever lost value for time periods greater than 10 years, and in the very few instances they did lose value, the amount of loss was less than 1.5%.1 With 10 years of protection, we are confident that you will not be forced to sell investments at a sizeable loss in order to sustain yourself.
On the flip side of loss protection, there is often a somewhat natural expectation that at the end of 10 years, returns should arrive at an “average” level. Sometimes returns do achieve a historically average level over 10 years, but receiving a lower than average return is actually quite common. To demonstrate, let’s consider stocks specifically, since the return pattern of stocks drives long-term portfolio results. Consistent data for the market has been tracked since 1926, and for the time period 1926 – 2015, stocks have earned compound returns of 10.0%. This time period spans eight decades. The table at left illustrates that stocks achieved returns at the average return level or higher in three of these decades, but they failed to do so in the other five decades. Most of the time stocks have failed to achieve their average return levels within a decade.1
To gain an even fuller perspective that goes beyond looking only at historical decades, we also studied all possible unique 10-year time periods. We looked 10 years back from the end of each calendar year, starting in 1936 and finishing in 2015. The outcome is very similar. Of 81 distinct 10-year periods, stocks do not achieve their long-term historical return level more than half of the time. Moreover, at times it has taken over 20 years to achieve an average level of return.1
Shouldn’t adding bonds to the portfolio help though? Adding bonds into the portfolio does reduce downside losses when the market declines in the short run, but it does not cause one to reach an average long-term return level any faster. We studied this by adding diversifying allocations of 30%, 40%, and 50% to bonds, and in all cases the dynamics were the same. More than half the time it took longer than 10 years to reach expected average return levels.1
Considering all of this, it seems that most of our investment perspectives are likely a bit warped from having enjoyed the positive return environments of the ‘80s and ‘90s. While we have heard a lot these last few years about “the new normal,” it actually could more aptly be called “the same old story.” Long-term average truly means very long-term, and achieving this average often does not occur within 10-years, frustrating as this reality may be.
When will my portfolio’s strategic positioning provide reward?
Our discussion to this point speaks of achieving average long-term returns. As you know though, we strategically position your portfolio, tilting its investments toward areas that we expect to add performance benefits over time due to long-term tendencies and trends. Looking across the globe, small sized companies and companies within emerging countries have historically delivered higher returns. Small U.S. and foreign companies are more nimble than their larger peers, and thriving businesses can grow at much faster rates than the general economy. Similarly, emerging market countries tend to experience higher economic growth rates than their developed nation counterparts.
Many of the nearly 40,0002 companies in these investment categories are not closely followed by financial analysts, and there is less investment capital chasing them, which often naturally results in lower valuations and better stock selection opportunities. Risks are present in these small and emerging categories, so portfolios must be carefully constructed to avoid excessive vulnerability to decline. With a thoughtful approach though, we believe long-term benefits are plentiful, and we allocate more than twice as much of our stock portfolio to small and emerging market companies relative to the global stock market.
Small and Emerging Market Companies
How long does it take though for these strategic growth-oriented tilts to provide performance benefits? It is encouraging to know that each of these growth categories can provide performance benefits relatively quickly. In fact, historically, benefits are achieved within three years more than half of the time. Good news too is that one or two growth categories are often providing benefit, even while another category may be lagging. (For instance, in recent years investments in small U.S. and foreign companies have provided benefits, even while investments in emerging markets have languished.) However, there are exceptional time periods, and when a growth category is out of favor in the markets, negative sentiment can last for a while. As a result, similar to what we found with regard to achieving average return levels, patience is required at times. In this case though, 10 years of time does provide performance benefits far more often than not.
Growth of $1.0 M (199-2014)
Muddling along in the global malaise that we have experienced over the last 15+ years is not unprecedented. Patience is often required while waiting for long-term returns to materialize and for thoughtful strategic positioning to provide benefits. This can be discouraging, and it is important to keep the bigger picture in view. With this in mind, we close by reminding you that the most important rate of return that you achieve is the one that enables you to realize your specific goals. In this regard, we intentionally take a conservative approach to your long-term planning. Our planning models incorporate the possibility of severe market drawdowns and extended periods of economic recession. That said, it’s important to periodically come back to review your long term goals and objectives, and we are always glad to help you revisit this.
1. Morningstar Direct
2. “The “not-so-small” Gap in Many Investor Portfolios: A Case for International Small Cap Equities.”
EAM Global Investors, LLC. 2015. & Morningstar Direct
Global Stocks: U.S. Large Stocks—Russell 1000, U.S. Midsized Stocks—S&P 400, U.S. Small Stocks—Russell 2000, Foreign Developed Large Stocks—MSCI EAFE, Foreign Developed Small Stocks—MSCI EAFE Small Cap, Emerging Market Stocks—MSCI Emerging Markets; Non-Traditional: Emerging Market Bonds—JPM Emerging Market Bond Index, High Yield Bonds—Barclays U.S. Corporate High Yield, Bank Loans—S&P/LSTA Leveraged Loan, Commodities—Bloomberg Commodity Index; Bonds: Intermediate Term Tax-Exempt Bonds—Barclays Municipal 5 Yr, Intermediate Term Taxable Bonds—Barclays US Aggregate, Short Term Bonds— Barclays U.S. Govt/Credit 1-3 Yr