What market returns can novice investors expect?

This article will show broad market returns for stock and bond investments.

Two previous topics in this series — Investment Novices — Financial Illiteracy and The Arithmetic of Wealth should be read prior to this topic.

Market Returns — Stocks

Stocks generally produce higher returns than bonds. But they also produce larger losses. To investigate stock returns, we will look at a broad index of US stocks. VTSMX, the Vanguard Total Stock Market Index, will be used to illustrate stocks.

This mutual fund is from Vanguard, a company that pioneered low-cost diversification via mutual funds. Vanguard is a highly respected company and offers a wide variety of mutual funds and also Exchange Traded Funds (ETFs). For now, we ignore the distinction between mutual funds and ETFs. There are other companies that offer families of funds that compete with Vanguard, e.g. Fidelity, T. Rowe Price and several others. Comparable funds from these different families generally produce similar results.

Image One shows what investing $10,000 in 1994 into VTSMX, produced:


IMAGE ONE

Stock Returns

The $10,000 initial investment grew to $85,000 over this 25-year period, a compound annual growth rate (CAGR) of almost 9% per year. This return is similar to the returns shown in the tables in The Arithmetic of Wealth. It is slightly lower than the 10% used in prior examples.

The important point is that no stock market expertise was required to buy (and hold) this one fund. This observation is important for those who believe they know nothing about the stock market.

The recently deceased John Bogle, founder of Vanguard, made it possible for anyone to achieve these results, even a monkey. Other mutual funds have done the same.

Stock Risk

A closer look at the results should create concern. While we may be pleased with the almost 9% compounded rate of return, the pattern of returns is troublesome.

Twenty percent of the years (5) produced losses. Three of those years were in a row (ending in early 2003) and one year, 2008, had a large loss (which began in 2007). Yearly results are artificial cut-offs determined by the Moon. However, the human pain of suffering through a major downdraft has no regard for artificial lunar cut-offs.

The maximum drawdown, shown in the summary line above, captures the drop across years. It represents the drop from your highest equity  to your lowest. For data above, two horrendous drops occurred and both seem to be about the same in percentage loss. The bigger of the two was almost 51%. Are you willing or able to emotionally or financially live through such a loss of equity?

Few can answer this question affirmatively. That is why the risk of an investment must be considered and managed. Maximizing return is not a strategy that we (or most people) should pursue. Maximizing return for some tolerable level of risk is appropriate. Risk and ways to mitigate it will be dealt with in a future article.

A Longer View of Stock Returns

For those interested in a broader look of stock performance, the following chart provides just such a look:

This chart covers more than a century of performance by the Dow Jones Industrial Average. Several points are worth noting:

  • The Dow Jones Industrial Average is hardly a diversified collection of US Stocks. It consists of large industrial stocks only and few of them.
  • Erratic performance (drawdowns) were larger in early periods than later periods. The logarithmic chart above allows this to be easily “eyeballed”. (If you are not familiar with logarithmic charts, search on the term.)
  • The largest drawdown occurred during the Great Depression in the early 1930s (a drawdown in excess of 90%).
  • The apparent “stagnation” from 2000 forward is not unlike that of the period of 1965 to 1983.
  • From 1900 to 2010, the Dow Jones average increased more than 1000%

Market Returns — Fixed Income

What we have referred to loosely as the market has been only stocks. However there are many other financial instruments in addition to equities (stocks). There are bonds, preferred stocks, commodities, options, futures, etc. and even hybrid sub-categories of these. When others speak of the market, they may be speaking only of stocks or may be speaking of stocks plus other financial instruments. For purposes at hand we shall concern ourselves only with the non-exotic — stocks and bonds. Thus, our “market” means stocks and bonds, unless otherwise noted.

Image Two below is that of another Vanguard Fund, the Total Bond Market Index Fund, VBMFX. Vanguard describes this fund as follows:  “… the fund invests about 30% in corporate bonds and 70% in U.S. government bonds of all maturities (short-, intermediate-, and long-term issues).” It is a diversified bond fund.

 

IMAGE TWO

Bond Returns

The top graph shows that $10,000 invested grew to $33,086, a compound annual growth rate of 4.90% per year. The return is substantially lower than that of stocks. Using our rule of 72 and comparing the two diversified funds, it will take stocks about 8 years to double in the Vanguard fund while it takes about 15 years to double your money in their bond fund.

Again, no special expertise or knowledge is required to achieve these bond returns. Merely buy the fund and go about your life.

There are bond relationships which are useful for investors to know. These will be discussed in a later piece.

Bond Risk

Based on the return differential, it might be natural to ask why anyone would invest in bonds rather than stocks.

The smoothness of the growth in profits in the bond fund provides a clue. While returns are lower. they are less volatile. Note how smooth the earnings curve is compared to the stock earnings curve. Losses are incurred with bonds but only three times during the time frame. Furthermore, all are reasonably small.

Market Returns and Risk

The fact that people buy bonds when they know they will get lower returns suggests that return maximization is not the primary consideration for most investors.

Simply put, investors like returns but they dislike risk. This reality must be taken into account when assessing assets and the design of a personal portfolio. Your risk tolerance will likely dictate the mix of assets that you hold. Highly risk averse investors will hold more bonds than lower risk averse investors.

Risk will be explored in a subsequent article.

 

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