Expectations can be a double edged sword. On one side, expectations represent what is most likely to take place, which can have practical value when talking about planning for the future. On the other hand, it can also set an “anchor” in the minds of investors, which could potentially cause anxiety when the probable ends up not being what is actually experienced.
There is no greater example, I believe, that best represents this dichotomy than the world of investing. Given how volatile markets can be from day-to-day, month-to-month, or even year-to-year, what is the most probable to happen rarely happens. Let me digress a bit.
In statistics, our best estimate of a random variable’s future value is its historical average. Markets have been shown to follow a “random walk” in which past prices have little to no effect on future prices. In other words, there are no discernible patterns in market prices. Therefore, our best estimate about the future return of the market over a given time period is its historical average. For example, based on data going back to 1928, the annualized return of the S&P 500 has been 9.74%, which represents our best estimate of the expected return of the S&P 500 going forward.
But how often have we seen the S&P 500 deliver 9.74% in any given year? Actually, never!
The chart below shows the annual returns for the S&P 500 from 1928-2016 in increments of 2% and the frequency in terms of the number of years we have seen a return within that 2% increment.
As you can see, we have yet to experience a single year in which the S&P delivered somewhere in between 8-10% per year. We experienced many years within 4-6% of that “expected return” with some extremes on both the very positive and very negative side, which has averaged out to a 9.74% annualized return.
This can potentially be alarming for investors if we do not manage their expectations appropriately. In reality, equity investors should expect a wide range of outcomes that are perfectly normal in terms of the probability of them happening. More accurately, an annual return between -10% and 30% is perfectly normal and should be in the back of investor’s minds when they are setting their expectations. As an advisor, it is important to remind investors of this expectation so that they do not change course if we happen to experience a deviation away from what we “expect” to happen.
We recently partnered with Dimensional Fund Advisors and produced a series of videos talking about managing client expectations. Enjoy!
About the Author
Mark Hebner - Founder, Index Fund Advisors, Inc.
Founder and President of Index Fund Advisors, Inc., and author of Index Funds: The 12-Step Recovery Program for Active Investors. He is a Wealth Advisor, with an MBA from the University of California at Irvine and a BS in Pharmacy from the University of New Mexico with a specialization in Nuclear Pharmacy.