No Such Thing As "Normal"

Most investors would say that 2008 was a very unusual year. The economy and financial system were rocked with abnormal events, and the prices of most financial assets fell sharply. Many are eagerly anticipating a time when the markets return to normal. Some may even be waiting until such a time comes to invest again.

There's only one problem: when it comes to the investment markets, "normal" conditions don't exist.

While a generation of investors has rightly learned that the stock market produces average returns of 11% per year over time, they have failed to learn how those returns are experienced in real time. We suspect that even among SMI readers, what follows will be something of a surprise.

One by-product of repeatedly hearing that the market returns roughly 11% annually on average is that many investors assume that's what a "normal" year looks like. But as the chart below shows, an expectation of yearly returns of close to 11%, with only occasional variation from that range, doesn't match the reality of how stock market returns have been delivered historically.

The chart assigns each year since 1926 (when the data series first began) to the column reflecting the stock market's return for that year. These are calendar-year returns only, and are what would have been earned by a portfolio composed of one-half large company stocks and one-half small company stocks.

If stock market returns were "normally distributed" around the market's long-term average gain of 11%, the chart would form the familiar looking bell-curve shape that most investors would intuitively expect. Most of the years would be clustered around the middle "8%-12%" column, with increasingly larger gains and losses becoming less frequent as you moved further away from average.

But that's not what the chart shows. Rather, it shows a relatively even distribution across a surprisingly wide spectrum of annual performance.

In Market Probabilities: What the Past Suggests About the Future, we used this same data set (from Ibbotson Associates) to demonstrate how staying invested in stocks over extended periods of time increases the likelihood of achieving "normal" returns. But those returns approach "normal" only when they are annualized over periods of multiple years. The individual year-to-year returns within those longer periods are quite volatile.

The point is this: longer investment time horizons do help accomplish the goal of realizing "normal" long-term returns. But they do so by accumulating a wide variety of annual returns, whose unpredictability is the only "normal" characteristic they share.

One implication of this is that it is nearly impossible to achieve the type of long-term results most stock investors desire without having to deal with the type of short-term volatility the chart above portrays.

How long is the "long-term" required to achieve the roughly 11% average return of the past several decades? That depends on how you look at it. In the "Market Probabilities" article, we saw that average annualized returns begin to gravitate towards the 10%+ range once holding periods reach 5-10 years. This is why we've frequently used those holding periods as cutoffs for defining when money should or should not be invested in stocks.

However, when a severe outlier like last year's loss of 35% occurs, that does change the equation somewhat. Given last year's losses, how long would a portfolio have had to be invested in stocks in order to end 2008 with an annualized return of at least 11%?

If only these full calendar years are considered, an investor would have had to invest way back at the beginning of 1982 in order to come up with an average annual return of at least 11% at the end of 2008. (Lowering the bar to 10% would still have required buying in January of 1991.)

That's rather shocking. But it makes some sense. Over the past 27 years, investors witnessed what many considered to be the greatest bull market ever. They've also felt the fury of two massive bear markets. Taken together over the complete market cycle, stocks have averaged almost exactly their long-term "normal" rate of return of 11%.

Over long periods of time, that's still a reasonable expectation. Just don't expect those returns to arrive "normally."

Mark Biller is Sound Mind Investing's Executive Editor. His writings on a broad range of financial topics have been featured in a variety of national print and electronic media, and he has appeared as a financial commentator for various national and local radio programs. Mark is also the Senior Portfolio Manager of the SMI Funds.

• Market Probabilities: What the Past Suggests About the Future
• What if this Bear Market is Different?
• Reflections on a History-Making Year for the Economy and Markets

• Got a question or comment about this article? Discuss it on our Message Boards.