Friends have told me that their 401 (k) haven’t increased much this year compared to the recent past.
My friends are right, given that the S&P 500 SPX,
turned negative the year following Thursday’s drop. But their frustration may reflect what behavioral economists call “recency bias.”
If you are suffering from this, you think that everything that has happened recently should continue indefinitely. Additionally, this affliction can make you forget that a stable or underperforming market is an opportunity to rebalance your portfolio and prepare it for less favorable investment environments.
The wonderful past
This is what the world looks like to my grumpy friends and no doubt to many other investors. In the six-year period ending in 2014, the S&P 500, including dividends, posted an astounding 159% return. That’s an annual compound return of about 17%.
It looks like equity investors are conditioned to big gains, even with the S&P 500 falling since the start of the year through Thursday. And it doesn’t matter that stocks only returned 2.1% in 2011 – that’s old history for those suffering from recency bias.
The truth is that a compound annualized return of 17% over an extended period of time is extremely rare. To put it in perspective, consider that Warren Buffett has achieved a compound annualized return of 19% in 50 years at the helm of Berkshire Hathaway BRK.A,
Over this half-century, the S&P 500, including dividends, has produced an annualized compound return of 10%.
And nothing should make you think the market can compete with Buffett’s long-term achievements indefinitely. The S&P 500’s 17% annualized return over the past six years is an absolutely unsustainable performance. This doesn’t mean that a crash is coming and everyone should sell all of their stocks, but some investors need to tone down their expectations considerably.
More perspective: over the 15-year period from 2000 to 2014, the S&P 500, including dividends, returned less than 5% on an annualized basis. Remember, if you start from a high assessment, you are unlikely to do well for a long time.
The index’s price relative to its average earnings over the past 10 years – the so-called Shiller PE – was over 40 in 2000, the highest on record. Now the measure is around 27, but its long-term average is below 17. While that is not a certainty, we are likely to experience another period of below-average returns.
Know its history
Recency bias could also make investors think that when markets go down, prices will recover quickly, as that is what happened the last time around. The idea of a three-year (or even longer) bear market, like the one from 2000 to 2002, is simply unimaginable.
However, investors should trust historical returns to realize that a bear market will be inevitable at some point. And there is no reason to believe that the bear will be hunted quickly. Annualized returns of 17%, anyway, will be impossible – especially since that is what just happened.
The following charts of the S&P 500 annual returns from 1970 should help you with this process. It shows an annualized compound return of 10%, but also periods of dismal returns. It also shows that the market hardly ever returns anything close to its long-term average in any given year.
So think of this year’s less forgiving market as a gift – you’ve had almost eight months after a massive six-year push to rebalance your portfolio based on its target allocation. This is the allocation you have put in place to help you withstand anything the markets can throw at you without causing you to quit stocks.
And if you haven’t set an allowance, now is the time to do it. Because after all, your wallet won’t continue to pile up like Buffett’s.