You can’t get away from volatility when you invest. Even if you hold a wide basket of different stocks or bonds through a fund such as an index tracker, over shorter periods of time the annual returns from the different asset classes can really vary.
The following graphic shows the range of annual returns seen from holding different US assets over various time periods, going on historical data from Barclays Capital.
Maximum and minimum real returns over different periods
Note how the variation in returns decreases the longer you hold
As we look from bottom to top, we’re looking at holding the asset for more years. The highest and lowest annualized returns over each time period are shown by the bars.
- Holding stocks (equities) for one year, for example, has seen a massive variation in annual return – sometimes as low as 40% over a year, and sometimes as high as near-60%.
- Hold stocks for five years, and the range of minimum and maximum annualized returns over the time period is much tighter: From around -10% per year over five years, to as much as 25%+ per year.
What volatility means for your investing
This graphic reveals some vital lessons for investors:
- Holding for longer allows good years to make up for bad years and vice versa, which averages out the returns.
- The small amount of dark blue to the left of the 0% line once you hold for longer than ten years shows how unusual it is for stocks to deliver real negative annual returns over longer time periods.
- Over one year, anything can happen!
- Volatility is the price you pay for potentially superior annual returns.
Also notice that because the average real annual returns from cash and bonds are low compared to stocks, a period of high inflation can see them still post negative real returns even after 20 years.
‘Real’ annual returns take inflation into account. A real return of -1% over 20 years means that factoring in inflation, your investment lost 1% of its spending power per year over the two decades.
US stocks have never posted negative real returns over periods longer than 20 years. This is why they’re the best asset class for long-term savings.
If you pick a simple ETF portfolio, save regularly, and rebalance your asset allocations every now and then, such fluctuations become much less critical – the good and bad periods of returns for the different assets are evened out.
{ 13 comments… read them below or add one }
I agree with you 100%, ETF’s seem to give you the best of all worlds. I also like the graphic, great way to visually demonstrate risk vs. return. I was surprised to see that bonds could yield a negative return after 20 years.
Have you ever looked at the Dow’s historical chart? You can find it here, and it’s amazing how much it’s changed just in my lifetime. When I was born it was a little under 1,000, then by the time I was 5 it had dropped to as low as 577 but jumped back to 1,014 a little over a year later. The people who didn’t give up on equities in 1975 and invested in the market at it’s lowest point almost doubled there money in a year.
Great article!
.-= David @ MBA briefs on: Do mass firings improve performance? =-.
Sorry, I must have a typo in the hyperlink.
The StockCharts.com graphic for the DJIA historical chart can be found here:
http://stockcharts.com/charts/historical/djia1900.html
.-= David @ MBA briefs on: Do mass firings improve performance? =-.
@David – Thanks for your thoughts. Yes, thanks to the bear market people currently have forgotten shares can go up as well as down Both the UK and US indices are up about 60% over the past 12 months since the bargain buying point in March. Friends who have kept trickling money into passive funds as advised over the past 3 years have done very well out of that bear market so far, although of course it could all plunge tomorrow, as ever.
More cool data to come next week, so watch this space.
ETF’s do provide huge benefits…but there are drawbacks as well.
As far as my money goes, I am most interested in return. Using the approach I have, I follow momentum and select the highest returning fund. Usually, the funds do better than the ETF but not always.
.-= Neal @ WealthPilgrim.com on: Why This 25 Year Old Should NOT Try To Make Extra Money =-.
you can’t get away from volatility when you invest.
I disagree, Investor.
I have a RobCast at my site entitled “Volatility is Optional.” It’s true that we cannot as individuals escape volatility. But as a society we certainly can.
If you think about it for a few moments, you see that all overvaluation and undervaluation in stock prices is the product of emotion. If investors were not acting emotionally, stocks would always be priced properly (that is, the market really would be efficient). What if we encouraged all investors to invest rationally (that is, to take price into consideration when setting their allocations)? Both overvaluation and undervaluation would become logical impossibilities and stocks would always be priced at fair value.
Fair value is the discounted value of the future income stream. The income stream increases by about 6.5 percent real per year because that is the average long-term return. So in a Rational Investing world, stock prices would go up by roughly 6.5 percent real each year like clockwork.
Volatility Be Gone!
Rob
.-= Rob Bennett on: My E-Mail to the Author of the Pop Economics Blog =-.
Gotta love the double return leveraged ETFs! Blow oneself up quicker!
.-= Financial Samurai on: Sometimes Saving Money Is About Principle =-.
I like the graphic quite a bit, it illustrates your concept pretty well, where’d ya find it?
.-= Ryan @ Planting Dollars on: Waikiki Site – Adding Wordpress and Thesis Theme via FTP to Bluehost =-.
Your graphic certainly does a good job of showing why it’s so important to know how long you’re going to be investing some money for. If it’s for next year’s holiday, stocks are probably a bad idea. It also ties in with the ‘glide path’ approach to asset allocation as you approach the withdrawl phase, which is another interesting topic in itself.
.-= UKValueInvestor on: February Update =-.
A great analysis of investing options. If you are focused on the long-term it really puts things in a perspective that brings confidence to investing.
.-= LeanLifeCoach on: Combating the Closing Techniques – The Assumptive Close =-.
Excellent explanation. I’m more of an invest-and-hold type, and this provides some validation to my thinking.
.-= RainyDaySaver on: Fix-It Friday: Know Your IRS Tax Forms =-.
For a very interesting analysis of volatility – and, just as important, correlation between asset classes, which is more subject to volatility than most people realise – see the Alliance Bernstein paper at http://tinyurl.com/ydctlh6
I have no connection to Alliance Bernstein, but do think they are on to something.
Thanks everyone for your comments. @UKValueInvestor, one way to sidestep equity volatility is to concentrate on income. That way you don’t need to sell to withdraw. Pretty feasible in the UK with our big yields, though there will be ups and downs of course.
@Rob, I know where you’re coming from with these comments because we’ve discussed it a dozen times, but in real life it’s not that simple. Aggregate stock market returns over the long-term may be around 6.5% real, but in the short term anything can happen because future earnings of any particular company or even the market as a whole are not that predictable.
As a result, the idea that volatility can be banished is dangerously wrong, in my view.
I’ll do a whole post on this to explain my thinking in more detail, so let’s leave it there. (If you’d like to discuss further on your own blog, link here and I’ll trackback and contribute in the comments if I get a chance).
Best regards.
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