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You’ve heard that the historic average return of the stock market, over the long term, is about 10% a year. But what does that really mean? Well according to the 2005 Yearbook published by Ibbotson (which I saw referenced in this article by Ed Easterling), that return is based on three components. The first, accounting for 5% of the return, is earnings growth. The second, which accounts for 0.9% of the return, is the increase in P/E ratios over the last 79 years from 10.2 (1926) to 20.7 (2005). And finally, dividend yield accounts for 4.5%. Add all that up and you get 10.4%.
That was a lot of numbers but the point is that big returns don’t just happen. And they can't be counted on as some kind of rule. The stock market averages and prices of individual stocks are based in reality. They are based on real numbers. Once in a while reality and the market splits like it did in the late 1990s. From 1995 to 1999 the Dow was up about 24% per year. For the same period the Nasdaq was up about 40% per year. If you were taking money out of the market at that time then you did very well. If, however, you were caught with money in the market in 2000 then you didn't do so well.
This brings me to the question of whether I can expect to average 10.4% returns in the future? Basically is the hype of articles like Dow 16,000 or books like Dow 36,000 real? Well according to the article I referenced above by Ed Easterling, the answer is no.
To summarize the article, P/E ratios simply can't double again from the current 20.7 to 41 so you can forget about 0.9% of the 10.4% returns of the past. Next Mr. Easterling points out that earnings can't be expected to grow as quickly in a time when inflation is low so his best case expectation is a reduction of 2% in earnings growth bringing the total return down to 8.5%.
Mr. Easterling's next point involves more complicated numbers using the ratio between P/E and dividend yield. He proposes that this will further reduce returns by 2-2.5% leaving us with the expectation of about 6% returns.
You won't hear analysis like this from the so called wall street experts out there. No, they rather hype the market with headlines like Dow 16,000 so you'll buy the next product they want to sell you.
Another danger of hype like this is that if you don't achieve this historic average of 10.4% you'll think there's something wrong with you. This could lead to riskier investments, or chasing the hot trend, which once it's hot you're too late anyway.
I just recently checked to see how my investments did this year and I did not beat the S&P 500. On January 3, 2006 the S&P 500 closed at 1268.80 and on December 11, 2006 it closed at 1413.04 for a YTD return of 11.37%. My investments, excluding new money, were up 9.75%. Not bad considering that most professional investors don't beat the overall market either.
So don't believe the hype and instead focus on realistic goals by developing an investment strategy that works for you.
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