Investors should take their lumps with a smile

Published in The Sunday Times on January 28th 2024.

“Charlie Munger and I always have preferred a lumpy 15% return to a smooth 12%,” the great investor Warren Buffet once said. I think I’d take a smooth 12%; alas, 4% is about the best you can do in 2024. 

2023 provided a great example of how lumpy the returns from stock markets can be. A good start to the year, a sell-off in the summer and a strong finish, culminating in a 26%+ return for the S&P 500 index in US dollars.

The concept of expected value

A relatively simple, but important concept taught in business classes is the idea of expected value. If there’s a 50% chance that you will win €40, and a 50% chance that you will lose €20, then the expected value of your winnings is €10. This is true even though there is zero chance of you winning that amount: you either win €40 or lose €20. This is a useful framework to consider when thinking about stock market returns. 

When you look at the history of stock market returns, the average yearly return for the S&P 500 has been just over 10% since 1926, assuming you reinvested all dividends. The most common annual outcomes are returns between +10% and +30%, while a loss of up to 20% is considerably more likely than a return in the 0 to 10% range,  which is where most forecasts lie.

Does the average return exist?

An “average” 10% year is actually quite rare, as in our expected value example. There are a few important things to consider about this. Firstly, the variability around this average, though mostly positive, is unnerving for all and unendurable for some. Secondly, volatility might be the most obvious risk from investing in stock markets, but not the most important one. Finally, the variability appears to provide fertile ground for market timing, spoiler alert: it doesn’t. 

The average return as it relates to the stock market, is a nonsense in the short term. Unless the average happens to be the most frequent return, which it isn’t, and unless it is not a highly volatile number, which it is, then the average is close to meaningless year to year. 

One of the reasons the equity premium has been so high historically, and why equities have strongly outperformed risk-free rates, is because many people find the volatility hard to stomach. Some can’t handle it all. If something is unendurable, it’s price usually gets bid down until we reach a level that is deemed fair compensation. Ergo, it’s the price you pay to play, so to speak. 

The variability around the average, as high as it has historically been, is arguably not the most relevant risk associated with investing. Of more consequence to a long-term investor has been the impact on returns for not keeping pace with inflation. The ultimate goal of an investment plan is to maintain or grow the real value of a portfolio. The stock market has provided the best protection against inflation historically. This may seem strange to read, but in that context, the stock market has provided greater financial security than the assets we traditionally think of as low risk i.e. cash and bonds.

Timing is a low-odds undertaking

Over the long term, stock markets generally tend to go up most of the time, punctuated by occasional sharp falls – usually associated with recessions. The term ‘occasional’ has important implications. Betting against a more persistent trend such as a rising market suggests you are likely to be wrong more often than right. In short, timing this is a low-odds undertaking.

The harsh reality for the would-be market timer is that the stock market’s annual return is decided by an unusually small number of days each calendar year.

If I was to poll readers on whether to take the risk-free rate (the smooth return) or take the market (the lumpy return) – it would be interesting to see what the split would be today. Davy performed analysis of the US market going back to 1955; the market return was better than the risk-free rate 68% of the time. But it’s not the frequency with which you are correct that counts. It’s the magnitude of correctness. The mean outperformance in those 68% of years was +15.8%. 

Updating Buffett

To update Buffett - you should prefer a lumpy 8% return to a smooth 4%. If you don’t, you need to understand why. If it is for financial reasons – you cannot afford to withstand the volatility, then that’s perfectly fine - the smooth 4% return (for as long as it lasts) is ample compensation. But if you prefer the smooth 4% because you don’t like the volatility – then that’s an emotional response. This can be dealt with through a proper financial plan. 

If you’re aiming to avoid risk – make sure you know which risk your avoiding. If you take the smooth return, you’re avoiding volatility, but you’re bearing inflation risk. That’s not a trade any long-term investor should be prepared to take. 
 

Source: Data is sourced from Bloomberg as at market close 29th December, returns are based on total indices in local currency terms, unless otherwise stated.

Gary Connolly is Investment Director at Davy. He can be contacted at gary.connolly@davy.ie or on twitter @gconno1.