How is the stock market performing?

Some market pundits will tell you that the market has performed unusually well recently.  Others will tell you that it has under performed.  Still others will tell you that the market’s performance is similar to its very long-term average.  All of them are correct.

Judging a market’s performance is highly dependent on the time period you choose.

Examine the table below:

Measurement period starting date Time period (in years) VFINX annualized return
09/30/11 1 30.02%
09/30/10 2 14.58%
03/31/09 3.5 20.79%
09/28/07 5 0.97%
03/31/05 7.5 4.76%
09/28/02 10 7.90%
03/31/00 12.5 1.48%
09/30/97 15 4.61%
09/30/92 20 8.41%
09/30/87 25 8.44%

This table shows the performance of the Vanguard S&P 500 Index fund, VFINX, for periods ranging from one year to 25 years, all ending on the most recent quarter-end of 9/30/2012.  The historical performance ranges from less than 1% per year to more than 30% per year, depending on the time period you choose.  The performance figures include the returns from dividends as well as capital appreciation.

Those who claim that the stock market has been performing well can point to the most recent year.  Those who claim that the stock market’s performance has been lackluster can cite five-year data.  And those who claim that the market’s performance is in line with very long-term averages can cite 10-, 20-, or 25-year periods.

If your intention is to mislead, you can carefully select your data set so that it will coincide with the narrative you wish to present.  For example, if I want to stress how poorly the market has performed (let’s say I am running for a national political position as an “outsider” and I want to paint the most pessimistic picture possible), I will choose a time period like the last five years.  On the other hand, if I want to stress how well the market has done, I will choose a period like the last year or 3.5 years, when the market was up by more than 30% and 20% per year, respectively.

These observations are correct, but do not really represent the typical market behavior over longer time periods.  Over very long time periods, the U.S. stock market performance has averaged between 8 and 10% before inflation, which is what the chart indicates for the performance of the last 20 and 25 years.  This level of performance is much closer to what I would expect for future market performance over the next 20 to 25 year time frame.  For shorter periods, it is reasonable to expect much more variation as depicted by the data.

One of the most common biases of investors is to focus on too short a time horizon.  Investors are overly obsessed with daily, weekly, monthly, and even yearly time periods.  Focusing on the short term is a good way to lose perspective and make poor decisions based on what are essentially random movements in prices, reflecting the unpredictable and ever-fluctuating optimism and pessimism of the world’s investment community.  In the very long run, these emotional swings even out, and the long-term performance closely tracks the underlying gains in productivity of the global workforce and the advances in standard of living of the world’s population.

Thus one should be wary about jumping to conclusions based on the market’s performance over short time periods.  There is a natural tendency to generalize and assume that the most recent experience will be repeated.  A longer-term look at market history will indicate that this is not a valid assumption.  The performance over a short period of time has little bearing on subsequent performance.

Another related error is to draw a conclusion from too few data points.  Consider a year’s performance to be a single data point.  Before making any assumptions about long-term averages, one should gather many data points, ideally at least 20 or 25.  In the chart above, the 20- and 25-year performances are close to the very long term averages.  Virtually all other time frames are too short, or have too few data points to draw any conclusions about what to expect for the long term.

One can easily conclude that performance can (and probably will) vary quite a bit from year to year.  This is “normal” behavior and is infrequently an indicator of a fundamental change in the long-term trend, in spite of how is it presented by the pundits of the day.

The bottom line is that investors who maintain a proper time perspective of their entire investment horizon (typically well in excess of 30 years) will be less likely to panic at the wrong times as a result of short-term market movements.  Such movements are not uncommon and will likely be countered by moves in the opposite direction.  In the long run, it is very reasonable to expect that stocks will appreciate at rates close to their historical averages.  It is imperative to keep in mind, though, how “long” long-term can be.  Think decades, not years.

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