Everyone wants to know what they can make. “What type of returns can we expect going forward?” gets asked a lot. What follows is a explanation of how cheap or expensive the market is and some educated guess on expected returns over the next several years.
So you end up getting something like this:
The market looks expensive. It’s roughly in the 21st percentile toward expensive over the past 25 years, meaning 79% of the time during that period the market is less expensive. What usually happens the following year when we’ve been at this level? On average, the market is up between 2% and 7%, so figure a gain of 4% to 6% on average. During those 25 years, the market rose 9% to 10% a year. Another way to think about this is the market is 12% to 13% more expensive than it has been traditionally.
That’s Joel Greenblatt’s response to the question. He usually does a great job of making things easy to understand. If you’re eyes glazed over after the first sentence, I get it. The number people care about is “gain of 4% to 6% on average.” That guesstimate falls roughly inline with most estimates.
This is usually the point where investors get into trouble. Expectations start to exceed reality.
The market has had a great run since ’09. It went from really cheap to somewhat expensive and the returns over that period show it. That “4% or 6% on average” may not be enough for many investors, especially those conditioned by past performance. When the market performs well we expect it to continue to perform well. When the market performs poorly we expect it to continue to do so. And the market almost always disappoints.
When the market goes up or an active investor outperforms, people pile in. When the market goes down or that investor lags behind, people pile out. They chase returns because that’s all they really have.
The market can’t earn average if it’s always outperforming.
Well, one scenario could be that it drops 12% to 13% tomorrow, and future returns would go back to 9% to 10%. Or you could underearn for three years at 4% to 6%. We’re still expecting positive returns, just more muted. The intelligent strategy is to buy the cheapest things you can find and short the most expensive.
Part of investing is accepting that “12% to 13%” drops are not only possible but necessary for the market to earn an average return. And if “12% or 13%” drops are too difficult to handle, then its time to find a strategy you’re comfortable with when market go up and down.
The basic idea is that the best strategy for most people is not only one that makes sense, but also one they can also stick with.
- The Long Run Is Just A Collection of Short Runs – M. Housel
- Trying to Explain the Inexplicable – Psych Today
- Turning Over Accepted Wisdom with Turnover – AQR
- The Dying Business of Picking Stocks – WSJ
- The Maturation of an Investor – MicroCap Club
- Peter Bevelin on Seeking Wisdom, Mental Models, Learning, and More – Farnam Street
- Why We’re Living in the Age of Fear – Rolling Stone
- Driving Lessons – Economist
- The Cult of the Expert and How It Collapsed – Guardian