Managing Expectations 

“Mr. Unrealistic Hopes, meet Ms. Unmet Goals.” Somewhere there’s a survey showing that Millennials (b: 1981-1996) who have never experienced a stock market correction (a decline of 10% or more), let alone a bear market (decline of 20% or more) have convinced themselves that the average growth of a diversified basket of large cap stocks is between 15% and 20% per year. And there is indeed some support for that. Since the most recent financial crisis ended in March, 2009, the market has returned 17.8% (annualized).

In 2009, when the crash happened, the oldest of the Millennial generation was 28 and the youngest was 13. Since then they’ve experienced only boom times. How boomy, you ask? At an 18% (rounded) return, principal doubles every four years (Rule of 72: divide yield into the Magic Number of 72 and you get “years to double”). Considering that an investment career of 40 years would subsume ten doublings, $1,000,000 would become $1 billion. So based on the Millennial’s personal experience, a stock market (total) return of between 15% and 20% might be not unreasonable. 

But should a different start date be selected, things would be much changed. For example with a data window extended to 50 years, from 1970 to 2020 (year to date), the average return would be materially lower. During that period the market dropped 10% or more on 8 separate times. The greatest decline was 56% (2007).  Now, it takes a 127% gain to recover from a 56% loss so this is no small matter. It is indeed true that losing money hurts more than gaining money satisfies. Spoiler alert: the average return over the 50 year period from 1970 to 2020 (YTD) was 7.3%. That’s not anywhere close to the Millennial’s experience.

A full economic cycle consists of two hemicycles: the rising interest rate period and the immediately following (or immediately subsequent) declining rate period. To develop a set of supportable expectations it appears the observation window would have to include both the rising and declining halves. In this article we will look at the data since 1970. This period includes both halves of a full secular interest rate cycle

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Review: “Mean   

There is no guarantee that a risk investment (as opposed to a zero-coupon Treasury bond, for example) will compound at a particular rate of return.  The investor may receive interest / rents / dividends, but because the market changes so much there is no certainty that at some unknown future period he can reinvest (compound) those sums at the previous rate. 

The value of the “mean” (think, “average”) is that it is a non-compounded number, and thus can be compared against other non-compounded returns. 

Basically, the mean is the average point in a continuum. It is a measure of central tendency. It is often illustrated with the classic bell-shaped curve, which is a probability distribution that shows data nearer the mean are more frequent in occurrence than data farther from the mean.

The mean, as a calculated number, does not imply that an investor will actually experience that figure. For example, assume the purchase of a bond whose contractual interest rate is 3% annually for the first three years, then 7% annually for the next three years at the end of which the bond matures. In the series of interest payments (3,3,3,7,7,7) the average (“mean”) interest is 5% (30 divided by 6). However, the investor will never see an interest check for 5% because the contract doesn’t provide for it. The contract allows only for the payment of 3% and 7% rates.

To know the mean point in a continuum is to know the historically, most likely average return over a period of time. The mean tells the investor what his average return is likely to be (i.e., “What am I gonna get?”). With that information the investor can move forward to computing the associated risk, “How likely am I to get it?

 

Review: “Standard Deviation  

Now that we know the statistically most probable return, the next step is to estimate how likely it might be. That’s where the term “standard deviation” comes in. One standard deviation is the range of possible returns, equally distributed on both sides of the mean, containing 68% of the samples. Because they are equally distributed, by definition 34% (half) of the samples are lower than the mean, and the other half (34%) are higher. Almost never will an investor receive exactly the computed average return, but 68% of the time the return he does receive will be within 34% (plus or minus) of the mean.

Example 1:  Given a population of 5, 10, and 15 the mean is 10 (30 divided by 3). The standard deviation (S.D.) is just a touch over 4. There is a 68% chance that the investor’s return will be between 6 and 14.

Example 2:  Given a larger population of 5,6,7,8,9,10,11,12,13,14,15 the mean is still 10 (110 divided by 11) but the greater number of data points means the Standard Deviation can be more refined. In this example, with 11 data points, the S.D. shrinks to 3.2 (rounded). That means there is a 68% chance (ie, one standard deviation) that the returns will lie between 6.8 and 13.2.

Notice that the cluster of likely returns is wider in Example 1 (plus or minus 4) and narrower in Example 2 (plus or minus 3.2). That is partly a function of the number of data points. The greater the number of data-points, the more precise one would expect the standard deviation to be and the more likely the actual return will approximate the mean. Remember, the narrower a standard deviation is, the better it is. That principle is not inviolable, but it’s the way to bet. 

Process   (1) Go to PortfolioCharts.com.  (2) Click on Portfolios. (3) Scroll down and click on My Portfolio. (4) Change default portfolio to something more appropriate (ie, 100% Large Cap Blend, normally abbreviated to LCB). Scroll down to (5a) Average Return and (5b) Standard Deviation.
Note that PortfolioCharts computes the annual Average (“mean”) Total Return of the LCB index to be 7.3% and the standard deviation (S.D.) at 17%, rounded. Voila! We now know what the average expected return is. And we know the chance it will happen: 68% of the time the return will range between 6.06% (math: 7.3% minus 17% = 6.06%) to 8.54% (more math: 7.3% plus 17% = 8.54%).

 

Application   

As a matter of interest, there are currently 9,599 mutual funds in the USA. This illustrates (a) that the stock market is huge, (b) that it can be sliced and diced many ways, and (c) each leads to a different result. It is therefore appropriate that the portion of the stock market used in this article be identified. 

The portion of the stock market employed in this example is the LCB (Large Cap Blend) index as provided by PortfolioCharts.com. This index consists of the companies constituting the largest 70% of the market. It necessarily includes both growth and value stocks because the market as a whole includes both. If a different slice of the market is required (e.g., only value stocks, or small cap stocks, etc), the reader is free to make whatever adjustments he fancies.

PortfolioCharts.com data (a) includes dividends, if any, (b) is adjusted for inflation, and (c) is a before-tax figure, because the same income could be taxed at widely varying amounts depending on the individual investor’s situation. Given a long-term inflation adjusted return of 7.3%, and presuming a long term dividend yield of 3%, the before-tax annual principal appreciation of this group of stocks, net of inflation, is 4.3%.

That means the inflation adjusted value of this portfolio will double every 17 years (Rule of 72: see above). A $1 million portfolio consisting only of LCB stocks would have doubled three times (rounded) since 1970. The first doubling would bring the $1 million portfolio to $2 million, the second doubling to $4,000,000, and the next to $8,000,000.  And that’s just from the growth of principal. The investor would also be receiving annual dividends she could use to purchase handbags and shoes and other needful things.

 

The Good  –  (Not in any particular order)

(1) Live anywhere. A stock market index doesn’t care where the investor lives. She could even be peripatetic, following the sun in the manner of Calliope hummingbirds, which breed in Southwest Canada during the summer and recuperate from their exhaustion by wintering in Central America.

(2)   Minimal management. The index might be easily rebalanced against other assets in the portfolio at intervals. If the investor’s liquid assets consisted of 70% indexed stocks and 30% bond index, it is a simple matter to re-balance the portfolio back to the original 70/30 split once every year or whenever the investor wishes.

(3)   Friction costs.  Small and micro stocks or unrated bonds might be difficult / costly to sell, but listed stock in the major companies or government bonds (and bonds of large corporate issuers, as well) can be transferred nearly immediately for very minor fees. The major discount brokers complete on-line transfers in seconds and charge little for the service.

(4)  Satisfactory returns.  As noted above, over the last half-century the inflation adjusted return from the stocks of the largest 70% US companies have (in the example provided) returned 7.3%. This is the sum of 3% (estimated) dividends and 4.3% principal appreciation. Invest $10,000,000 and have $300,000 annually in cash flow plus 4.3% cumulative appreciation. The inflation adjusted principal doubles every 17 years.

(5)   Example use: Volatile, high return, savings. As noted in the beginning of this series of articles, lenders are increasingly requiring, as a condition of lending, that the borrower have sufficient liquid assets available after the purchase / refinancing is funded. Although it varies with the market, the often quoted requirement is 10% of the loan amount. Thus a $2,000,000 loan would require the borrower to have $200,000 in cash or cash equivalents available after paying all costs of the loan. This can be a sizable portion of the borrower’s liquid net worth. Consider a building valued at $3,000,000 with a proposed loan of $2,000,000, leaving equity of $1,000,000. The borrower can’t use that $1 million in retained equity towards “reserves” because it’s not liquid.

With a $2 million loan the owner’s required post-funding liquid reserves would minimally be $200,000 (10% of the loan amount). Many investors invest their reserve funds in various ways. A bank deposit might yield 1.5% ($1,500) annually, while over a sufficient time line the Large Cap Blend group of stocks yielded 7.3% ($7,300). The difference is $5,800 a year, an appreciable sum .

 

The Bad   

In the short term, stock values go up and down for any reason and for no reason. Sometimes the declines are serious. The real (net of inflation) return for the S&P 500 index was a negative 1.4% during the decade of the 1970’s. The first decade of the current century saw a negative 3.4% return. Negative real returns over a decade or more are sour raisins. But it must be remembered that even including these decades of loss, the average total return over extended periods of time has been an annualized, inflation adjusted gain of 7.3%.

Nonetheless, to invest in the stock market, the investor should have the ability (both financial and emotional) to ride out these inevitable declines. To expect one’s principal to grow every successive year, or every decade is a low probability event. But, to repeat, over time – decades – the real return of large cap stocks has been around 7% annually.

 

This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional. Klarise Yahya is a Commercial Mortgage Broker specializing in difficult-to-place mortgages for any kind of property. If you are thinking of refinancing or purchasing real estate Klarise Yahya can help. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email info@KlariseYahya.com