Lessons Learned from Wading Across a River with an Average Depth of 6 Feet

Looking back on the year that has been we can definitely say it has been a good year for headline stock indices. The S&P 500 gained 29%. The Dow Jones Industrial Average added 20.1%. The Nasdaq 100 gained 28%. The past year’s outstanding returns only adds to the amazing, compounded returns achieved by each of these indices over the past 5 year. Since 2017 the Nasdaq has gained over 250%, the Dow 100.4%, and the S&P 500 133%. The average annual return over this period for each index is 28.5%, 15.39%, and 18.42%, respectively. The Sharpe ratio for the S&P 500 since 2017 is over 1.1. Sharpe measures the relationship of returns to volatility. For context, the average annual return for the S&P 500 from 1986-2016 was 10.2% and the Sharpe Ratio was .50. To say that the last five years have been tremendous is an understatement.

However, the returns being tremendous should not imply unprecedented. During the mid to late ‘90s, from 1993-1999 the S&P 500 averaged 21.44% with a Sharpe Ratio of 1.23. Unfortunately, we all know how that ended. Returns for the subsequent 10 years, 2000-2009, were dismal. The S&P 500 averaged a loss of 1.03% annually, while the Nasdaq averaged -6.4% annually. This highlights the nature of averages in the world of a volatile stream of returns. Gains and losses tend to cluster rather than exhibiting a smooth path. In order to reach a long-term average of, say 10%, for the S&P 500 years of great returns are necessarily offset by years of sub-par returns.

This does not mean, however, that next year is the year that it all begins to revert. It may be or it may not be, I don’t make those calls, at least not in print. Year over year calls tend to be fruitless and unreliable in my estimation. A more reliable prediction from the recent massive returns is that the returns over the next 10 years will likely have no resemblance to the last 7-10 years.

What does that mean for your investment portfolio and your retirement plan? First, if you are basing your projected income or projected portfolio value at retirement using the last 10 years as a reference, you may want to lower your expectations. It is always safer assuming a longer-term average rather than shorter-term averages. Second, while diversification over the last 10 years has only meant realizing lower returns, diversification and risk-balancing will be much more crucial in the years ahead. While a portfolio of 50% stock and 50% bonds has under-performed the S&P 500 by nearly 9% per year since 2017, the same portfolio outperformed the S&P 500 by roughly 7% per year from 2000-2008. Given that we are in a much different interest rate environment today than we were in 1999 achieving the same returns in a 50/50 portfolio may not be attainable, but it should certainly help whether the storm if stocks begin mean reverting.

As a financial advisor I believe it is my duty to be somewhat of a “Debbie Downer.” Psychologically our brains are wired to get caught up in euphoria. Bubbles are as old as time because our brains are wired that way. But data is there to intercept that thinking if we just take the time to listen. We hope that you all have had a good year. David and I want to wish you the best for the coming one and thank you for all your support.

Thanks for reading,

Zach and Dave

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