I've read that the stock market has posted long-term average annual returns of 10 per cent. Is this number accurate, and what sort of gains do you think investors should expect in the future?
Stock market returns vary widely depending on the time period studied. That volatility makes it difficult to predict future returns with any accuracy.
For example, in the decade that started Jan. 1, 2000, the S&P 500 sank about 9.1 per cent – or a bit less than 1 per cent annually – including dividends. So that was a terrible time to own stocks. The 10 years before that, however, were a great time for equity investors: The S&P 500 soared 431 per cent, or about 18.1 per cent on an annual basis.
Now let's look at a longer period.
A Credit Suisse study by Elroy Dimson, Paul Marsh and Mike Staunton examined returns for stock markets around the world from 1900 through 2008. In the United States, stocks grew at an annualized rate of 9.2 per cent, including reinvested dividends. In real terms – after inflation – the return for stocks was 6 per cent, and for bonds it was 2.1 per cent.
Canada produced similar results, with an annualized real return of 5.9 per cent for stocks and 2.1 per cent for bonds.
Despite short-term volatility, stocks are still the place to be. They produced the best long-term returns in all 17 of the countries Credit Suisse studied, with most markets posting real returns of 3 to 6 per cent over the 109-year span.
Another conclusion of the Credit Suisse report is that dividends matter – a lot. Assuming all dividends were reinvested, one U.S. dollar would have grown to $582 in real terms over the period in question. Had the dividends been spent instead, the $1 would have grown to just $6 – an annual return of just 1.7 per cent annually.
"Reinvested dividends dominate long-run returns," the study concluded. "The longer the investment horizon, the more important is dividend income."
What returns can investors expect in the future? Well, don't count on the double-digit growth of recent decades to resume.
"We were spoiled by the high returns of the 1980s and 1990s, when equities seemed a surefire route to getting rich quickly," Credit Suisse said.
"Today, as we look ahead … returns could easily come in short bursts rather than gently over time. We need to take a long-term view, and be ready for the inevitable periodic setbacks, which can be severe, while recognizing that there are risks to being out of equities as well."
Justin Bender, an associate portfolio manager with PWL Capital in Toronto, crunched the data and came up with what he believes are realistic return expectations for various asset allocations. For example, an "aggressive growth" portfolio consisting of 20 per cent fixed income and 80 per cent equities (tilted toward small-cap and value stocks, which have historically outperformed) has an expected annual return, before inflation, of 6.8 per cent.
A balanced portfolio split 50-50 between fixed-income and stocks has an expected return, before inflation, of 5.75 per cent.
After deducting estimated inflation of 2 per cent and fees of, say, 1.5 per cent (which is less than what many mutual fund investors pay), we're left with a real return of 3.3 per cent for the aggressive portfolio and 2.25 per cent for the balanced portfolio. Taxes would take another bite out of these returns.
That's a far cry from 10 per cent.
There are several lessons here. The first is to keep your fees as low as possible. The second is to invest a portion of your portfolio in equities which, though volatile in the short run, are still the best-performing asset class. The third lesson, Mr. Bender said, is that investors "have to start being more realistic about what their portfolio is going to do."