Many investors and the financial media appear to believe the stock market exists to deliver reliable returns year after year. When the market doesn’t provide positive returns in a particular year, they think something must be wrong. The error these investors and the media make is not recognizing that the positive returns only come as an average return over time — not every year.
Since the stock market must either go up or go down, you may think stock market returns are a 50/50 gain/loss proposition. However, since 1926, the S&P 500 Index has been positive roughly 75% of calendar years; only about 25% of those years have produced a loss. Obviously, if an investor could avoid owning stocks in the negative years, their return would be even higher than if they used a buy-and-hold approach. With this in mind, some investors attempt to time their investments in stocks. But almost every study has concluded that trying to time the market is futile for the vast majority of investors.1
And yet, despite all the evidence that stocks are the highest-returning asset class over the long term and that almost nobody can time the market consistently, investors and the financial media usually treat market corrections as “something gone wrong.” In fact, market corrections — sometimes severe corrections — are a feature of successful long-term investing, not a “bug” in the system to be fixed.
Since 1928, U.S. stocks have produced an average annual return of about 10%, while U.S. Treasury bonds have returned less than 6%2. However, US stock returns have ranged from -43.5% in 1931 to 56.7% in 1933. Those one-time extremes mask the fact that during this historical time period, only 10 years produced worse than -11% annual returns, while 53 calendar years provided positive returns over 11%.3
Long-term investors in stocks have been well-rewarded for accepting the risk of short-term losses compared to the gains they could achieve in cash or bonds. It’s important for investors to understand that they are getting “paid” for the uncertainty of year-to-year returns through the higher, long-term returns that stocks provide compared to “safer” assets like US Treasury bonds or cash. And it’s also important that they accept the roughly 25% of calendar year declines as a normal aspect of the way stock markets work, not as a problem they must solve — as painful as those times may be. This is the link between returns and risk. An investor simply cannot obtain the higher stock returns without accepting the year to year stock market risk of declines.
Most people simply cannot stomach the volatility and occasional significant market declines that come with investing only in stocks. As a result, there are some strategies within portfolios that help mitigate some of this year-to-year stock market risk and can even boost returns. For example, bonds can help stabilize a portfolio and reduce the volatility and risk associated with stocks. In addition, strategic rebalancing from time to time can ensure that no one segment of the portfolio becomes outsized, creating unnecessary risk. Finally, taking advantage of occasional losses through tax-loss harvesting can provide additional benefit on an after-tax basis.
If you have questions about investing or your investment strategy, consider speaking with a member of our team.