How often in the last few years have investors said they’re staying out of the equity markets because of the volatility we’ve experienced recently? Many of them are waiting on the sidelines “until things are back to normal.” That raises the question: what exactly is normal for equity returns?
Usually when people think of “normal” returns, they look at historical averages. According to the Credit Suisse Global Investment Yearbook, stock markets in the developed world delivered an annualized return of 8.5% over the last 112 years. Using that average as the midpoint in a range, it seems fair to say that “normal” historical stock returns are between 6% and 11%.
You might conclude, therefore, that it will be time to get back into equities once we’ve seen a couple of years with returns in this neighbourhood. That would be signal that things have “returned to normal,” right?
To test this idea, I looked at equity index returns for Canada, the US and international developed markets (in Canadian dollars) since 1970. Sure enough, during this 42-year period, annualized returns for all three asset class returns were within our expected range: 9.1%, 10.6%, and 8.9%, respectively. But what about year-by-year returns? If you were investing throughout these four decades, what years would you have considered “normal”?
Normal annual returns are extreme
You may be shocked to learn that a portfolio with equal amounts of Canadian, US and international stocks would have posted returns between 6% and 11% exactly five times in the last 42 years. Think about that: in any given year, the chance that stock returns will be within this “normal” range was less than one in eight.
Now let’s consider the probability of more “abnormal” outcomes. If the average long-term return for stocks is 8.5%, let’s look at years where returns were a full 10 percentage points more or less than that. It turns out that there were 11 years with losses of at least –1.5%, and 17 others with gains of at least 18.5%. In other words, the probability of a significant loss or a huge gain was 67%, or two years out of every three.
You can see all of these data by downloading my spreadsheet. You can also experiment by changing the upper and lower limits of what you consider “normal.” The spreadsheet will tell you how many years fall within your specified range.