Dan Cupkovic, CFP®, is Director of Investments at ARGI.
Investing in the stock and bond markets is not for the faint of heart, as substantial rises and falls in asset values often occur. Yet, the prudent investor realizes that the purpose of investing in both the stock and bond markets is to provide greater long-term returns, relative to “safe” cash deposits (such as money market funds and certificates of deposit). Astute long-term investors will avoid ad hoc, emotional reactions to shorter-term, yet often significant, fluctuations (especially downturns) in market values.
For the data in charts linked, as a proxy for the U.S. stock market, my company utilized the Standard and Poor’s 500 Index. The index gained an annualized average of 10.46% from 1926 through 2021. S&P 500 Index and CPI-U data is derived from Dimensional’s Returns Web software, which in turn is sourced from Ibbotson data courtesy of Stocks, Bonds, Bills and Inflation Yearbook, Ibbotson Associates, Chicago (annually updated works by Roger C. Ibbotson and Rex A. Sinquefield). Inspiration for the format of this chart and for this article is derived from “The Rewarding Distribution of U.S. Stock Market Returns” from Dimensional, which utilized CRSP data for U.S. stocks but which did not adjust returns for inflation.
The annualized average gains are notable; however, you must give due consideration to the effects of inflation, as a central purpose of stock market investing is to possess a return exceeding the rate of inflation over the long term. Accordingly, in the charts, I subtract the rate of inflation or add the rate of deflation (as measured by the U.S. Consumer Price Index for Urban Areas) for each annual, 10-year or 20-year period shown, to obtain the “inflation-adjusted” (or “real”) returns of this U.S. stock index.
Examining Annual ‘Real’ Returns for US Stocks
Negative returns are more impactful on an investment portfolio than positive returns; for example, a 20% decline in portfolio value must be followed by a 25% positive return in order to return to the original portfolio value. Keep in mind that investing always includes a risk of losing the principal and fluctuating in value. The S&P value itself cannot reflect any potential expenses associated with managing a portfolio, like transaction costs and fees charged by investment advisors.
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The foregoing assumes all dividends and realized capital gains are reinvested and no deduction is made for taxes that might be due on any distributions of capital gains, dividends or interest, or otherwise incurred by an investor.
As seen in the chart linked above, the U.S. stock market (as represented by the S&P 500 Index) posted positive inflation-adjusted returns in only 69% of the calendar years from 1926 through 2021. And, as an indication of the inherent short-term volatility of the stock market, approximately 63% of the calendar-year inflation-adjusted returns were at least 10 percentage points above or below the average inflation-adjusted returns of 6% to 7% per year.
Examining 10-Year ‘Real’ Returns for US Stocks
As stock market investing is a long-term endeavor, I want to next view an estimate of the inflation-adjusted returns for the Standard and Poor’s 500 Index over each decade ending from 1935 through 2021.
As seen, there is a greater probability of positive inflation-adjusted stock market returns when a decade-long time horizon is considered. Still, in 27 of the 85 decade-long periods surveyed, the inflation-adjusted rate of return was less than 5%, and 10 of those decade-long periods possessed negative average annual returns.
Examining 20-Year ‘Real’ Returns for US Stocks
Historically, over even longer periods of time, the rewards from investing in stocks are usually far greater than the rewards from investing in “safe” short-term fixed-income securities. Hence, I want to next view an estimate of the inflation-adjusted returns for the Standard and Poor’s 500 Index over each 20-year period ending from 1945 through 2021.
As seen, in all of the foregoing 20-year periods surveyed, the stock index possessed average annual returns exceeding that of the rate of inflation.
Notice how following some of the “darkest hours” in U.S. history—such as the years of World War II, and even several years during the Great Depression—there were some of the strongest 20-year returns.
The successful investor withstands both market upturns and downturns, adopts a prudent asset allocation and emphasizes broad diversification among select asset classes and individual securities. The prudent investor also resists the urge to flee the stock market during market downturns, with the knowledge that a prudent goal of stock market investing is to capture the long-term returns that the capital markets offer.
Diversification and asset allocation help you spread risk throughout your portfolio, so investments that do poorly may be balanced by others that do relatively better. Neither diversification nor asset allocation can ensure a profit or protect against a loss.
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