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Positive Expected Returns

“What’s the stock market going to do?” If you have read our past newsletters, you know that we are not market prognosticators. It is difficult for anyone to predict future market movements with any accuracy or consistency, and we make no attempt to do so in our approach to portfolio management. Nevertheless, academic theory suggests that the expected return in the market is always positive. How can this be?

An investor who is completely risk-averse will invest solely in U.S. Treasury securities, which are backed by the full faith and credit of the U.S. government and are essentially risk-free. Historically, stocks have been riskier than bonds. The only reason for investors to accept this higher risk is that they expect a higher return, which stocks have provided. From 1926 to 2017, the U.S. stock market had an average annual return of 10.2% compared to 5.5% for long-term treasury bonds. This difference in returns (4.7%) is referred to as the equity risk premium, which is the higher expected return that investors require to risk their money in the stock market.

According to economic theory, stock market prices are adjusted daily to provide this higher expected return. If this were not the case, investors would take their dollars elsewhere, resulting in downward pressure on stock prices until the market was priced appropriately to provide a positive expected return. Adjustments in stock prices based on new information occur quickly. As a result, there is a positive expected return built into the stock market based on its current valuation at all times.

Of course, this does not mean the market always goes up. Weaker than anticipated economic data or unforeseen geopolitical problems can send stocks downward in a hurry; however, this is based strictly on new information, not on past performance. A common misconception is that when the stock market has been going up for a while and is hitting new highs, it is due for a fall. An analysis of the S&P 500 from 1926 to 2017 shows that the average annual return after new market highs was positive over the ensuing one, three, and five-year periods, as shown below. Interestingly, the average annual return was also positive after market corrections of 10% or more.

Source: Dimensional Fund Advisors

The take-home point is that predicting market returns is hazardous because they are influenced by unknowable future events rather than past performance. Instead of relying on market forecasts, investors should harness the power of the market as an efficient information processing system to help structure their investment portfolios. Stock prices reflect the collective wisdom of millions of buyers and sellers whose actions cause prices to adjust up or down in real time to provide positive expected returns going forward. While there is no guarantee that these returns will be realized, historically the market has gone up more often than it goes down. Since 1926, the U.S. stock market has risen 68 out of 92 years, or about 74% of the time.

One way to increase your chances of realizing a positive return in the stock market is to invest over a long time horizon. This is why it is important to choose a level of equity exposure that you feel comfortable with, so that you can stick with your asset allocation strategy over the long run.

As always, please feel free to contact me if you have any questions, comments, or concerns.

Jeffrey J. Brown, MD CFA Principal, Shearwater Capital

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