Much of our focus the first six weeks of this year has revolved around financial planning — specifically the MoneyGuidePro® offer recently extended to SMI Premium Members by SMI Advisory Services. The cover article of our upcoming March issue, scheduled to be released at the end of next week, details some of the valuable new features Members will have access to in the full version of MoneyGuidePro®. Among those is the ability to project their plans using any rate of return they want. This is important for good planning, as the future may not look like the past, and wise planners will want to know what their financial future might look like if the high returns of the past are harder to come by in the future.
While planning tools that rely to at least some degree on historical returns are helpful and necessary, there's an inherent danger in focusing on average rates of return. Investors who stay invested over the long haul may, in fact, earn returns close to the stock market's long-term average (which has been 9.8% over the past 113 years). But they'll rarely feel like they're earning that type of average return, because the market doesn't plod along steadily. Rather, it races ahead, producing dizzying gains during bull markets, then crashes back to earth during bear markets. When it all comes out in the wash, it may look like a steady 9.8% per year. But along the way, an investor's returns are nothing of the sort. Which explains why most investors wind up with substantially inferior returns — the emotional swings of the journey cause them to make counterproductive moves at both the highs and lows of the cycle.
This is illustrated beautifully by Justin Sibears of Newfound Research in the article Anatomy of a Bull Market. Altering the view of average annual returns to map them by bull and bear markets, we see the market's "zoom/crash" dynamic at work:
Only one of the 23 market cycles since 1903 has averaged returns close to the market's long-term average, and that one ended 100 years ago in 1916.
Mr. Sibears points out:
Consider this: since 1903, there has not been a market cycle with a single digit annualized return.
Ten of the twelve bull markets had annualized gains greater than 15%. Similarly, annualized losses exceeded 15% in ten of the eleven bear markets.
In other words, the market is typically surging ahead or plunging lower. Rarely does it "cruise" along at a comfortable speed.
So while effective planning dictates that we use some sort of "normal" long-term rate of return for our calculations, it's important that emotionally we're prepared for a very different kind of investing experience. Creating a portfolio that enables you to stay invested through the market's emotional ups and downs is a crucial — and vastly underrated — element of actually earning those long-term rates of return.