December 8th, 2016 | by Gregg S. Fisher, CFA, "Invest with Reason"
Feeling Great about the Market Right Now? Time for Some Perspective
- Investors in US equities have enjoyed a good run in the markets recently, but returns from January 2000 to today give investors considerably less to cheer about (only 4.4% annualized for US stocks).
- When investor behavior and taxes are factored in the results are even more disappointing.
- While investors can neither predict nor control what the next 16 years in the markets will bring, they should focus on what they can control, such as taxes, costs and behavior, to maximize what they earn on their investments in all market environments.
Most investors have smiles on their faces these days. After all, since the highly contentious November 8 Presidential Election, the S&P 500 Index has scaled new heights and returned 3.2% through December 5. Year to date (to December 5) on a total return basis, large-company stocks have returned 10.1% (which is, coincidentally, very close to the Index’s annualized return since January 1926).
But how have stocks performed on a longer-term basis, say since the start of this millennium? The answer is, not well; in fact, pretty terribly. From January 2000 to November 2016, the S&P 500 returned 4.4% on an annualized basis (the MSCI All-Country World Index performance was even worse at 3.62% annualized). From January 2000 to December 2015, the 16-year compounded return was only 4.05%. We went back and studied all rolling 16-year periods in the market’s history, from January 1926 to November 2016, rolling each period forward one month at a time. Of 900 such 16-year rolling periods, large cap stocks returned less than 5% in only 9% of periods.
So for most investors—and for those of us who manage money on behalf of investors—it’s clearly been a challenging 16 years. From January 2000 to November 2016, even a 5-year Treasury Note returned 4.83%, implying a negative risk premium for holding stocks instead of the lower-risk Note. A balanced index fund returned 5.24%, with lower volatility than the stock index.
Investor Performance: Even Worse than you Think
Consider also what investors have had to endure since January 2000 (see Exhibit 1) to earn that parsimonious 4.4% return in stocks: the bursting of the dot-com bubble in 2000 and a 50% market crash; 9/11 and the US-led wars in Iraq and Afghanistan; the housing bubble, Global Financial Crisis and another stock crash in 2008; a series of economic crises in Greece and other members of the eurozone; the Brexit vote in the United Kingdom and an ugly US Presidential campaign season.
To add insult to injury, in the real world very few investors earned even that slim 4.4% annualized return recorded by the S&P 500 Index. First, most investors purchase actively managed funds instead of index funds, despite abundant research showing that active funds underperform over extended time periods. For instance, an S&P Dow Jones Indices study found that 85% of US large-cap funds underperformed the S&P 500 Index during the ten years from July 2006 to June 2016; during the five years to June 2016, a full 92% of active managers trailed the index.
Keep in mind also that those returns are before taxes. Using a leading low-cost S&P 500 Index fund as a proxy and making some assumptions for tax rates (40% income tax rate; 20% capital gains tax rate), we estimate that an investor in a taxable account surrendered about 75 basis points, or 17% of his 4.4% annual return, to taxes during 2000 to November 2016.
Finally, let’s be realistic: how many investors, buffeted by news headlines such as those I’ve cited above, actually buy and hold onto an index for 16 years? Very few. Research by Gerstein Fisher and others (see for example, “Past performance is indicative of future beliefs“) shows that investor behavior (such as buying high, selling low, and similar self-destructive market-timing decisions) tends to cut annual investment returns by one point or more.
So if you add up the loss of points for investor behavior, the tax drag, and investing in active funds that trailed the index, most investors are probably fortunate if they earned even half of that absolute 4.4% annualized return for 16 years.
So, what does the past 16 years say about the next 16 years? No one knows if returns will be as dreadful, better or worse. The fact that the trailing 16 years’ returns ranked in the bottom decile of 900 observations in US market history (since 1926) may mean nothing at all for the next 16 years.
We continue to suggest that, since investors cannot control market returns, they should focus on aspects of investing that will enhance their investment experience, such as controlling costs, hewing to an appropriate investment strategy, and practicing adroit tax management discipline (such as tax-loss harvesting) every year. If you employ a financial advisor, a good chunk of his or her job and value-add should be focused on improving your investment experience.