The primary subject of my book is comparing the risk premium with risk pooling as a source of funding for retirement goals. An important step is to first make clear what the risk premium is and how it relates to an investment portfolio. Fundamentally, investors prefer certainty to uncertainty. A bond provides a known yield with contractual protections helping to ensure that its return is realized if held to maturity. Stock returns are more uncertain, as they depend on the future performance of the company as well as on changing investor perceptions about the company.
If a stock offered the same average return as bonds, but with greater volatility around that average, the typical risk averse investor would not be willing to purchase it. Risk averse individuals are willing to pay more to receive certainty, so less-volatile assets should have lower expected returns. To accept risk, investors will seek a higher expected return over time than they could receive from more reliable bonds. That higher expected return represents the risk premium. Stocks can generally be expected to outperform bonds over time, but such outperformance is not predictable and there can be reasonably long stretches in which stock returns lag bonds.
A good starting point for understanding the historical returns fordifferent asset classes is with Morningstar and Ibbotson Associates data. Theyhave compiled US financial market returns since 1926 in their SBBI (Stocks, Bonds, Bills, and Inflation) Yearbook. This data is usuallythe source for calculating average historical market performance and creatingassumptions for future portfolio returns. We can use this data as a startingpoint for understanding about historical stock performance.
Exhibit 1.1 provides historical averages and volatility for differentmarket indices in this dataset for both nominal and real terms. With thisdataset, small-capitalization stocks have offered the most return potentialalong with the most volatility. Their simple average arithmetic return was 16.2percent during this time period in nominal terms, with a standard deviation of31.6 percent.
Arithmetic mean returns are calculated by adding up all the annual returnsfrom the historical data and then dividing by the number of years in the dataset. The standard deviation is a measure of volatility in terms of the degreeof fluctuations experienced around the average outcome. Approximately,two-thirds of the historical returns fell within the range of 31.6 percent moreor less than the average of 16.2 percent. That range is -15.4 percent to 47.8percent. The remaining one-third of historical returns were even more extremein either direction. Volatility reduces the predictability for realizedreturns. When thinking of risk as volatility, we generally care most about therisk for losses, but if market returns are symmetric around an average, thenusing standard deviation will work just as well.
While the arithmetic mean represents the average historical growth rateover a single year, it does not reflect the growth rate over a longer period.The average compounded return represents the growth rate over multiple years,and it is always less than the arithmetic mean for any volatile asset.Increased asset volatility causes the compounded return to fall by even morerelative to the arithmetic return. For long-term investors, it is thecompounded return that matters.
To understand this volatility effect on compounded returns, realize thatpositive and negative returns do not create a symmetric impact on wealth.Negative returns must be followed by even larger positive returns to get backto the initial point. For instance, a 50 percent drop requires a 100 percentgain to get back to the starting point. For this reason, wealth will grow at alower compounded rate than the arithmetic average. Compounded returns take alarger haircut as the volatility of returns increases. With the high volatilityof small-capitalization stocks, the compounded return was 11.8 percent, a full4.2 percent less than the arithmetic average. The 11.8 percent return reflectsthe fixed growth rate for the asset class that supported its cumulative returnover the entire historical period.
Next in the chart are large-capitalization US stocks, as represented by theS&P 500 index since its creation in the 1950s, and a more general index oflarge companies in the years before that. The arithmetic average forlarge-capitalization stocks was 11.9 percent (roughly 12 percent, which is whythat number is used on occasion as an estimate for stocks returns) with astandard deviation of 19.8 percent (roughly 20 percent). The volatility impactwas such that these stocks grew over time at an average compounded rate of 10percent.
Exhibit 1.1 Summary Statistics for US Financial Market Annual Returns and Inflation, 1926–2018
Source: Own calculations from SBBI Yearbook data available from Morningstar and Ibbotson Associates.
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This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon.