Do Stocks Return 10% on Average?

Ben Felix

28 Mar 202408:43

Summary

TLDRIn this insightful video, Ben Felix from PWL Capital challenges the common belief that stocks will return 10% or more per year on average, explaining that this expectation may lead to misguided financial decisions. He delves into the history of stock market returns, highlighting the difference between nominal and real returns, and emphasizes the impact of inflation on investment gains. Felix also critiques the reliance on recent U.S. market history for setting future expectations, citing research that suggests more modest long-term returns. He advocates for a more realistic approach to estimating expected returns, considering global stock performance and current market valuations, ultimately advising investors to prepare for lower than anticipated stock returns.

Takeaways

🧐 The common belief that stocks will return 10% or more per year on average is often misguided and can lead to poor financial decisions.
📈 The origin of the 10% return figure is based on US stock market performance from 1950 to 2023, which may not be a reliable indicator for future returns.
🔄 It's crucial to differentiate between nominal and real returns, with real returns being more reflective of actual purchasing power and thus more important for investors.
🌐 The real return on US stocks from 1950 through 2023 was 7.63%, indicating that even exceptional returns should be viewed in real terms.
📊 Rising stock valuations, driven by falling discount rates, suggest lower expected returns in the future rather than higher, contrary to investor expectations.
🔍 A 2002 paper by Eugene Fama and Ken French suggests that the higher returns post-1950 are due to rising stock valuations and not necessarily sustainable for future investment strategies.
🎯 The historical US equity risk premium for 1872 to 1950 is close to the realized premium over the same period, suggesting that past performance should inform future expectations.
🌍 Global stock returns, excluding the US market, have been lower, with an average real return of 4.35% from 1900 through 2023.
🤔 The 'equity premium puzzle' refers to the higher than predicted returns of the US stock market, which researchers attempt to resolve by examining global data and considering economic models.
📝 PWL Capital uses a comprehensive approach to estimate expected returns, considering global historical data, removing valuation changes, and accounting for current market conditions.

Q & A

What is the common belief about stock returns that Ben Felix addresses in the video?
-The common belief that Ben Felix addresses is that stocks will return 10% or more per year on average, which he suggests is misguided and can lead to poor financial decisions.
What does the nominal return of 11.32% for US stocks from 1950 to 2023 not account for?
-The nominal return of 11.32% does not account for inflation. It is important to consider real returns, which do take inflation into account, as they provide a more accurate picture of the actual value growth of investments.
What is the real return on US stocks from 1950 through 2023?
-The real return on US stocks from 1950 through 2023 was 7.63%. This figure is adjusted for inflation, providing a more accurate measure of the growth in value of these investments.
What does the term 'Equity risk premium' refer to?
-The Equity risk premium refers to the excess return that stocks provide over and above the return on risk-free assets, such as government bonds. It compensates investors for taking on the additional risk associated with investing in the stock market.
Why do rising stock valuations suggest lower expected returns?
-Rising stock valuations suggest that stocks are currently expensive relative to their earnings or assets. High valuations imply that a significant portion of the potential for growth in stock prices has already been realized, leading to the expectation of lower future returns.
What is the 'rear view mirror bias' in investing?
-The 'rear view mirror bias' is the tendency of investors to assume that the high returns experienced in the past will continue indefinitely into the future. This bias can lead to overconfidence and unrealistic expectations about future investment performance.
How does the concept of 'survivorship bias' affect historical equity premium calculations?
-Survivorship bias occurs when the analysis focuses only on companies that survived over a certain period, leading to an overestimation of the historical equity premium. This is because failed or underperforming companies are excluded from the sample, which can skew the results to appear more favorable than they actually were.
What is the historical real return on global stocks from 1900 to 2023, excluding the US market?
-The historical real return on global stocks from 1900 to 2023, excluding the US market, is 4.35%. Including the US market, the figure is 5.16%.
What is PWL Capital's estimated real expected return for a total market index fund portfolio?
-PWL Capital's estimated real expected return for a total market index fund portfolio is 4.62%, with a nominal expected return of 7.24% assuming an expected inflation rate of 2.5%.
Why is it important to have accurate estimates of expected returns for financial planning and portfolio management?
-Accurate estimates of expected returns are crucial for making informed financial decisions. They impact how much an individual needs to save for retirement, how much they can spend during retirement, and when they can retire. Over time, even small differences in expected returns can lead to significant changes in these outcomes due to the compounding effect.
How often does PWL Capital update its estimates for expected returns, and where can these estimates be found?
-PWL Capital updates its estimates for expected returns twice a year, and these figures are made available for free on their website.

Outlines

00:00

📉 Debunking the 10% Stock Return Myth

This paragraph discusses the common misconception that stocks will return an average of 10% per year. Ben Felix, a portfolio manager at PWL Capital, explains that this belief is misguided and can lead to poor financial decisions. The historical data shows that from 1950 to 2023, US stocks delivered a nominal annualized return of 11.32%, but when adjusted for inflation, the real return was significantly lower at 7.63%. The paragraph emphasizes the importance of distinguishing between nominal and real returns, and how rising valuations, rather than fundamentals, have driven up stock returns. It also references a 2002 paper by Eugene F. and Ken French, which suggests that the higher returns post-1950 are not sustainable due to the current high valuations and lower expected returns.

05:01

🌍 Global Stock Returns and the Equity Premium Puzzle

The second paragraph delves into the concept of the equity premium puzzle, where historical US stock returns have exceeded predictions from economic models. It compares the US stock returns to global stock returns, highlighting that the global real stock returns from 1900 to 2023 were 4.35% excluding the US, and 5.16% including the US. The paragraph discusses research that suggests a median real return of 5.28% for international stocks and 4.78% for domestic stocks. It also addresses the rear view mirror bias, where investors may assume that high historical returns will continue indefinitely. The paragraph concludes by presenting PWL Capital's expected real return estimates of 4.62% and nominal 7.24%, taking into account current valuations and expected inflation. It underscores the significant impact that even small differences in expected returns can have on financial planning and portfolio management.

Mindmap

Keywords

💡expected returns

Expected returns refer to the anticipated profit or loss from an investment over a specific period. In the context of the video, it is crucial for investors to have accurate estimates of expected returns to make informed financial decisions, such as how much to save, asset allocation, and whether to invest or pay off debt. The video emphasizes that the commonly believed 10% annual return on stocks may not be a reliable estimate and that a more realistic figure, taking into account historical data and current market conditions, is necessary for sound financial planning.

💡nominal returns

Nominal returns are the face value of an investment's profit or loss without adjusting for inflation. While nominal returns can give a sense of how an investment has performed, they do not provide a complete picture of its purchasing power over time. The video script points out that nominal returns do not account for the erosion of value due to inflation, which is why real returns, which do account for inflation, are more meaningful for investors.

💡real returns

Real returns are the investment returns that have been adjusted for inflation, providing a more accurate reflection of an investment's purchasing power over time. In the video, the importance of focusing on real returns is emphasized because they indicate the actual growth in value that an investor can expect after accounting for the decrease in purchasing power due to inflation.

💡valuations

Valuations refer to the assessment of the value of a company or asset, often based on financial metrics like price-to-earnings ratios. In the context of the video, valuations are critical because they can influence expected future returns. High valuations suggest that a stock is expensive relative to its earnings and may预示着 lower future returns, while low valuations may预示着 higher returns.

💡equity risk premium

The equity risk premium is the additional return that investors expect to receive for taking on the higher risk associated with investing in stocks compared to less risky investments, such as bonds. It represents the compensation for the extra risk that stock investors take on. The video emphasizes that the realized equity risk premium from 1951 to 2000 was much higher than the historical average, suggesting that the higher returns during this period were not typical and should not be used as a basis for future expectations.

💡rear view mirror bias

Rear view mirror bias is a cognitive bias where individuals believe that the future will resemble the past, particularly in terms of investment returns. This bias can lead investors to overestimate future returns based on recent historical performance, ignoring changes in market conditions or valuations. The video warns against this bias by explaining that past high stock returns, driven by rising valuations, may not be sustainable in the future.

💡survivorship bias

Survivorship bias is an error in analysis that occurs when data is collected only from entities that have survived or performed well, while those that have not are excluded. This can lead to an overestimation of the performance of a particular group or investment. In the context of the video, survivorship bias may have contributed to the historical US equity premium by overlooking companies that did not survive or perform as well as those that did.

💡global stock returns

Global stock returns refer to the overall performance of stock markets around the world. The video script uses global stock returns to provide a broader perspective on historical investment performance, showing that returns outside of the US have been lower than the exceptional returns seen in the US market. This information is important for investors to consider when estimating expected returns and diversifying their portfolios.

💡equity premium puzzle

The equity premium puzzle refers to the economic phenomenon where stocks have historically provided much higher returns than can be explained by economic models. This discrepancy between the observed returns and the predicted returns based on these models is known as the equity premium puzzle. The video discusses this puzzle and suggests that historical US stock returns have been high enough to be considered a puzzle, as they are much higher than what most economic models would predict.

💡financial planning

Financial planning is the process of evaluating an individual's or organization's current financial status and developing a strategy to achieve their financial goals in the future. In the video, the importance of accurate expected return estimates for financial planning is emphasized, as it affects decisions related to saving, investing, and retirement planning.

💡portfolio management

Portfolio management involves the selection, monitoring, and adjustment of investments to achieve a client's financial goals. It includes decisions about asset allocation, diversification, and risk management. In the video, the speaker, Ben Felix, explains that PWL Capital applies sensible expected return estimates to portfolio management to provide better financial advice to their clients.

Highlights

The belief that stocks will return 10% or more per year on average is misguided and can lead to poor financial decisions.

The 10% return figure originates from US stock market history, particularly from 1950 to 2023, which delivered a nominal annualized return of 11.32%.

It's crucial to differentiate between nominal and real returns, with real returns being more significant for practical financial planning.

The real return on US stocks from 1950 through 2023 was 7.63%, indicating that the approximate 7% real return is still exceptional.

The pre-1950 US stock market delivered a real annualized return of 5.57%, suggesting that historical periods should also be considered when estimating expected returns.

Rising stock valuations, driven by falling discount rates, do not guarantee repeating the high returns of the past and may indicate lower expected future returns.

Eugene Fama and Ken French's 2002 paper suggests that the higher return post-1951 is due to rising stock valuations and falling discount rates, which point to lower expected returns.

Survivorship bias and the perception of the US market as 'safe' have contributed to the historical US equity premium, driving up stock valuations.

Global real stock returns from 1900 through 2023, excluding the US market, were 4.35%, and including the US market were 5.16%.

Research indicates a median real return of 5.28% for international stocks and 4.78% for domestic stocks, reflecting a lower expected return than the often cited 10% nominal return for stocks.

The historical US stock returns have been termed an 'equity premium puzzle' as they are higher than most economic models predict.

At PWL Capital, expected returns are estimated by considering global historical returns, removing valuation changes, and accounting for current valuations.

PWL Capital updates their real expected return estimates to 4.62% and nominal 7.24%, assuming 2.5% expected inflation, twice a year.

The difference between a 10% and a 7% expected return is significant, impacting decisions like savings for retirement and the timing of retirement.

Stocks have historically beaten bonds and are expected to continue doing so, but their expected returns are not as high as commonly believed.

Using the best historical periods for the best-performing stock market as an estimate of expected returns can be misleading, especially when current market valuations are high.

For more information on PWL's approach to financial planning and portfolio management using sensible expected return estimates, one can book a meeting with them.