Investment - long-term

What’s The Really Long-Term Return On Stocks? Feb. 02, 2017 6:49 AM ET42 Comments2 Likes Eric @ SERVO profile picture Eric @ SERVO 1.12K Followers http://servowealth.com Retirement planning, tax and estate planning

Contributor Since 2012

I founded and manage Servo Wealth Management, a Registered Investment Advisor (RIA) firm that helps people achieve financial independence, a secure retirement, and positions them to leave a meaningful financial legacy.

Summary Stocks should make up the majority of most long-term investors’ portfolios. Diversification across asset classes, which almost no one gets right, is essential for the long-term success of a stock portfolio. By looking at stock market returns across different global markets and time periods, we can better understand what the true long-term return of stocks is and what patterns emerge within. Historical stock market data and durable return patterns should serve as the basis for all long-term planning and investing decisions. In a recent article, I discussed the virtues of a significant long-term allocation to stocks for all investors - not just pre-retirees, but those in retirement as well. Central to the premise of the article was the emphasis on diversification within stocks, a concept that I find many people still don’t fully understand or embrace.

Of course, you want to hold a lot of stocks within a given asset class, but the primary focus should be on the overall asset allocation and a broadly diversified portfolio. Different asset classes have had remarkably different long-term returns, and the pattern of returns have been remarkably consistent across different markets and time periods. This is information you absolutely must understand to be a successful investor, not to mention information that is incredibly difficult to come by. So let me outline what the really long-term return on stocks has been.

First, we have quality data on US stocks going back to 1928.

Asset Class

Annualized Returns

US Large Cap Stocks

+9.5%

US Large Value Stocks

+11.3%

US Small Cap Stocks

+12.2%

US Small Value Stocks

+13.5%

Large cap stocks have produced returns of +9.5% per year, the source of the oft-repeated comment that stocks “do about 10% a year.” But ignoring value and small cap stocks understates long-term returns. Large value stocks returned +11.3% a year, small cap stocks did +12.2% a year, and small value stocks +13.5%.

US stock returns have been good, for sure. Almost no one denies that. What we do hear is that the US market has been the “winner” amongst the rest of the world, and non-US market returns have been far lower. International (Europe and Asia) data isn’t available until 1970 for large cap stocks and 1982 on small value stocks (and we’ll get there), but we can first look at the returns on UK stocks dating back to 1956:

Asset Class

Annualized Returns

UK Large Cap Stocks

+10.2%

UK Large Value Stocks

+13.2%

UK Small Cap Stocks

+14.2%

UK Small Value Stocks

+16.7%

Looking at the returns on UK stocks over the last 60+ years, we don’t find that the US evidence overstates results, but understates them! UK large cap stocks were within range of US returns - +10.2% vs. +9.5%, but UK large value, small cap, and small value returns were all 2% to 3% per year higher. And the pattern of returns was the same: Large value beat large cap, small beat large, and small value beat small cap. Coincidence based on random outcomes from the two largest stock markets of the last century? Let’s keep looking to find out.

As I mentioned before, we can measure international developed large cap stocks since 1970 (+9.3% a year - only 0.2% per year less than the return on US stocks from 1928-2016), but to pull in all four corners of the international market, we need to measure returns since 1982:

Asset Class

Annualized Returns

International Large Cap Stocks

+9.0%

International Large Value Stocks

+11.4%

International Small Cap Stocks

+11.6%

International Small Value Stocks

+13.6%

This is an interesting outcome. We’re looking at about 35% of the world market (the US makes up about 55%), over a period of time that is fairly long but completely different from the US example. And, yet, asset class returns are almost identical. Int’l large cap stocks returned +9.0% per year, int’l large value stocks did +11.4%, int’l small cap stocks did +11.6% and international small value stocks did +13.6%. Think about this for a minute - international large and small value stocks over the last quarter century have generated returns within 0.1% a year of US stocks from 1928-2016. At some point, we have to stop thinking this is noise and realize we’re seeing the signal.

If you did the math, however, you realized that US and non-US developed markets only comprise about 90% of the world market. There’s another 10% to account for, and those are emerging markets. The data on emerging market stocks only dates back to 1989, but we can measure returns sorted along large/small and value stock dimensions. What do we find?

Asset Class

Annualized Returns

Emerging Markets Large Cap Stocks

+9.6%

Emerging Markets Value Stocks

+13.2%

Emerging Markets Small Cap Stocks

+11.4%

Clearly, you either think I’m making these numbers up (I’m not, trust me), or the outcomes are just eerie. Emerging markets large cap stocks returned +9.6% per year (0.1% per year more than US large cap stocks since 1928). Emerging markets value stocks (large cap and small cap combined) returned +13.2%, and emerging markets small cap stocks returned +11.4%. Each one of these results is what you would have predicted had you only looked at developed markets over their longest available periods. About 10% stock returns, value beat growth, and large cap beat small cap, by very familiar amounts.

Suffice it to say, at this point, we are buried by the historical data on long-term stock returns, and it all lines up exactly as you would expect: Large cap stocks return 9% to 10% a year over time, large value stocks do 1% to 2% more, small cap stocks 2% or so more, and small value stocks about 4% per year more.

These figures should be the basis for your long-term investment planning decisions. They should also provide you the conclusive evidence why simply holding a basket of large cap stocks, or just US stocks, is insufficient. All individual asset classes can go extended periods with poor returns, an outcome that can be offset by diversifying across different asset classes. They’re different because they don’t go up/down at the same time. And ignoring smaller and more value-oriented stocks will cost you several percent a year in missed-out-on returns.

Of course, you may wish to knock a few percent off all future returns for planning purposes, if for no other reason than conservative plans are usually more successful plans. But not because stocks are “overvalued.” We’ll debunk that myth tomorrow. For today, the takeaway is that there’s been a very clear and dependable pattern in global stock market returns: They’ve been good, and the smaller and more value-oriented the asset class, the better the results have been.

Source of data: DFA Returns Web

Indexes:

US large cap = DFA US Large Cap Index

US large value = DFA US Large Value Index

US small cap = DFA US Small Cap Index

US small value = DFA US Small Value Index

UK large cap = MSCI UK Index

UK large value = DFA UK Large Value Index

UK small cap = DFA UK Small Cap Index

UK small value = DFA UK Small Value Index

Int’l large cap = MSCI EAFE Index

Int’l large value = DFA Int’l Large Value Index (FF Int’l Value Index prior to 1990)

Int’l small cap = DFA Int’l Small Cap Index

Int’l small value = DFA Int’l Small Value Index

EM large cap = MSCI EM Index

EM value = DFA UK Large Value Index

EM small cap = DFA UK Small Cap Index

Past performance is not a guarantee of future results. Index performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.

This article was written by

Eric @ SERVO profile picture Eric @ SERVO 1.12K Followers I founded and manage Servo Wealth Management, a Registered Investment Advisor (RIA) firm that helps people… http://servowealth.com Retirement planning, tax and estate planning

Contributor Since 2012

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Strategic Investor profile picture Strategic Investor 04 Feb. 2017

Comments (2.77K) The problem with these sorts of empirical or “evidence based” approaches is an epistemological error. It confuses what we can observe with what we know; past performance is no guarantee of future returns and extrapolating in this way, even “knocking off a few points for safety” is dangerous. Though it has basically worked well over the past 90 years or so. (Looking backwards in 1885, investing in buggy whips seemed like a can’t lose proposition, too). This kind of approach reminds me of the story of the bacteria that double every hour. After a few days or maybe a week, their cumulative mass exceeds that of Earth. Within a month, their mass exceeds that of the universe. One has to ask oneself how plausible it is that the value of ownership in corporations can grow faster than economic activity forever. Since most of the value of stocks is in the present value of future earnings, either corporate earnings have to grow faster than national income forever or the prices people are willing to pay for a $1 o ff u t u ree a r nin g s ha s t o in cre a se * f ore v er * . I t see m s u n l ik e l y t ha tp eo pl e w i ll b e w i ll in g t o p a y l o t s m ore t han$ 1 for a $1 of future earnings, so surely this has a limit. That leaves earnings. Can corporate earnings grow faster than gross national income forever? Since earnings are a component of national income, at some point, like our bacteria, if they keep growing faster than national income, they will come to be larger than national income. So, really national income is a limit on corporate profits, too. In a global environment, global income is the limiting factor. A considerable share of profits from US firms comes from faster growing foreign markets, so profits could grow a bit faster than US GDP over the long term. As to the “confirmaiton” offered by foreign markets. Additional evidence like foreign market experience should not be confidence-inspiring, either. It should instead ask us to question the assumption that foreign markets had a meaningfully different experience. Large firms, which constitute most of the valuation of public equity markets, have basically been selling into the same marketplaces on similar terms of trade during at least the last 70 years. Why would their results be different? But since these datasets are not independent, they cannot or should not be treated as if they are.

Like Eric @ SERVO profile picture Eric @ SERVO 06 Feb. 2017

Comments (1.13K) So, you’re saying “this time is different”?

Like Strategic Investor profile picture Strategic Investor 06 Feb. 2017

Comments (2.77K) I’m asking how wise it is to assume that trees grow to the sky.

Like Eric @ SERVO profile picture Eric @ SERVO 07 Feb. 2017

Comments (1.13K) Well, for every $1 ina d i v ers i f i e d s t oc kin d e x p or t f o l i o in 1970, yo u ha v e$ 400 today. How high in the sky are you asking about?

Like Robert.from.Ct profile picture Robert.from.Ct 03 Feb. 2017

Comments (2.55K) @ Eric Another great article----------espec… about the small value premium. Regards,Bob

Like Eric @ SERVO profile picture Eric @ SERVO 03 Feb. 2017

Comments (1.13K) Thanks Robert, Glad you found it helpful!

Like Ray Lopez profile picture Ray Lopez 02 Feb. 2017

Comments (2.62K) But, having said all the above, “the entire gain in the U.S. stock market since 1926 is attributable to the best-performing four percent of listed stocks” http://bit.ly/2kY3K8l What happens if you fail to diversify and miss that 4%? Uh-oh.

Like N NothingsEasy 02 Feb. 2017

Comments (33) If small cap/value indexes perform better over time than large cap/value indexes, would it be better to weight your portfolio this way. In your past articles you’ve defined your DFA Equity Balanced Strategy Index as 20% S&P 500 Index, 20% DFA US Large Value Index, 10% DFA US Small Cap Index, 10% DFA US Small Value Index, … Based on the information you’ve presented here, would you change this to 10%, 10%, 20%, 20%, … I ran the portfoliovisualizer from Jan 1999 - Dec 2016 using the DFA Equity Balanced Strategy Index, original weighting vs. the swap I showed above. CAGR : 4.84% vs. 6.3%

Like Eric @ SERVO profile picture Eric @ SERVO 03 Feb. 2017

Comments (1.13K) Good question! Theoretically, putting 100% of your portfolio in small value stocks would earn the highest returns. And some advisors who sell performance actually advise this and write books about it. I’m not those advisors. I’m worried about client/investor outcomes, and so I believe diversification is a better strategy, #1. #2, there’s a limit to how much “tracking error” any investor can stand as their portfolio deviates wildly from market averages. During these times, long-term data and “faith” only go so far. Better to hold a portfolio that is more diversified with only moderate tracking error that you can stick with than to shoot for the fences and wind up striking out. Tracking error comes from large amounts of small/value and foreign stocks. I tend to take a more moderate approach to both. I don’t think there’s a 1-size fits all portfolio allocation solution, fwiw. I have a client who I felt like would be very tracking error sensitive and I have her in a very mildly tilted portfolio. I have other clients who are 100% value, and 40/60 large to small. But, in general, I find that a 60/40 large-to-small weight makes the most sense. I split US large 50/50 into “market” and “value”, and US small and int’l is where I go 100% value. And I’m typically 70/30 US to foreign. There’s a real art to designing an allocatoin that an investor can stick with, it’s something that almost 20 years and thousands of investor interactions have really helped me with.

Like BoomBoom99 profile picture BoomBoom99 02 Feb. 2017

Comments (2.8K) Eric, Do you have data on Canadian stocks?