Something for the Pitch Book

Brian Pornoy, Director of Investor Education at Virtus, recently included the following thought-provoking chart in his commentary titled What Does the Stock Market Owe You?:

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The chart encompasses daily snapshots of the total return (i.e., dividends included) of the S&P 500®, a broad index of U.S. stocks, from 1928 until today. Reading the picture from left to right, what you’re looking at are “rolling” time periods of increasing duration. A rolling time period thinly slices our windows on market returns over whatever period we choose to define them. So, for example, a rolling three-year period could be the market returns from November 1, 1953 to October 31, 1956. The next three-year period would be November 2, 1953 to November 1, 1956. And so on. I looked at the rolling returns over periods ranging from one to ten years in length. All in, it encompasses tens of thousands of observations.

Pornoy’s conclusion were as follows:

  • Notice that the average return over these different periods is remarkably consistent. It’s about 10%. Not surprisingly, many people reflexively believe that “the market” returns about 10% per year. They’re not whistling Dixie. Based on history, that’s about right.
  • Yet that mode of thinking—asking “what’s the average?”—reflects the brain’s bias toward locking onto specific point estimates. We prefer to fixate on a precise number and reject, often subconsciously, thinking in statistical, probabilistic terms. In other words, we don’t naturally play the odds. Sure, to say instead that the market returns “about 8-12%” per year is a baby step in the right direction. Unfortunately the world is much messier than that. The following observations, therefore, force us out of our comfort zone, as they force us to think in terms of dynamic ranges and probabilities.
  • For each of the rolling periods, I show the maximum and minimum returns: the biggest gains and the biggest losses. Thus, over thousands of rolling one-year periods going back to 1928, the largest one-year gain was 171% and the largest one-year loss was -71%. This range is massive. (Note that the most extreme results occurred during the 1930s.)
  • What this tells us is clear: In the short term (please forget days and months, even a year counts as short term), stock market returns are extremely volatile; they are basically random. The fact that the rolling one-year “average” is around 11% tells you nearly nothing about what the market can and will deliver you. Over the past century, we’ve seen one-year periods when some investors nearly tripled their money, while others lost more than two-thirds of it.

Those investors/pundits who are predisposed to be bullish can use data such as this to argue for aggressive allocations.  After all, what’s not to like about those average and max returns!  Those investors/pundits who are predisposed to be bearish can use the same data to argue for conservative allocations.  The latter group will simply focus on the worst outcomes over those rolling time periods.

It also occurs to me that an advisor who has embraced Dorsey Wright into their practice could use that chart to demonstrate to a client or prospect the value that they can bring to the table.  We all know what the market has done in the past.  From that history, we can clearly observe the massive degree of variability.  Armed with that knowledge, I’m not sure how many investors will continue to be fully comfortable with a strategic approach to asset allocation that offers little flexibility.

Something to consider adding to the pitch book.

Past performance is no guarantee of future returns.  Dorsey Wright is a research provider to Virtus.

HT: Abnormal Returns

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