Personal Finance: Lower Stock Returns and Higher Volatility to Test Investors


Investors have a reputation for dumping their stocks when the market nose-dives, a reputation earned over decades of, well, dumping their stocks when the market nose-dives. Yet by all accounts, when the market tumbled last spring during the Covid-19 outbreak, an overwhelming majority of investors hung on to their stocks or bought additional shares as prices fell. 

What accounts for investors’ newfound grit? Perhaps they’re becoming savvier with their money, as the billions of dollars moving into low-cost index funds from high-priced actively managed funds suggests. Or maybe the market declined and recovered too quickly last year for investors to react —  the drop from peak to trough took just more than a month, and by August the market notched record highs.

But there may be another explanation, one that suggests investors may not be so poised next time the market slumps. The years bookended by the 2008 financial crisis and coronavirus featured one of the all-time great bull runs, and a market that hot for that long has a way of bolstering investors’ resolve. They’re more likely to remain invested having experienced the thrill of a surging stock market, and those accumulated gains help cushion the fall.  

And there were gains aplenty. The S&P 500 Index returned 16.9% a year from March 2009 to January 2020, including dividends. Only three bull markets during the past 150 years produced comparable gains over a comparable period — the Roaring ’20s, the post-World War II boom and the nearly two-decade long rally during the 1980s and 1990s.

But the years ahead are likely to be much different. Fund giant Vanguard Group, which runs the biggest S&P 500 fund on the planet, estimates that U.S. large-cap stocks will return somewhere between 2.4% and 4.4% a year over the next 10 years, well below the S&P 500’s long-term average of roughly 10% a year. And Vanguard isn’t alone. There’s near unanimity among big financial firms that the U.S. stock market will produce sub-average returns in the coming years.

Why does Vanguard expect so little from the market? The culprit, not surprisingly, is high valuations. “The most important factor explaining long-term expected return in the stock market is starting valuation,” Vanguard economist Qian Wang told me. “Our forecast for U.S. stocks, especially large caps, has steadily turned lower in recent years due to stretched valuations. We expect contracting valuations to be the biggest drag on the market going forward.” 

If that outlook proves true, stocks won’t be nearly as exciting over the next decade, and the gains will be barely perceptible. Will that be enough to keep investors in the market the next time it tumbles?    

It’s a timely question not only because returns are likely to be lower going forward but also because volatility is likely to be higher. The years between the financial crisis and the pandemic were some of the calmest on record. Vanguard sees that ending, too. It estimates that the volatility of U.S. large-cap stocks, as measured by annualized standard deviation, will rise to 16.4% over the next 10 years, an increase of about 30% from the post-financial crisis period.

No Surprises

The stock market’s long-term volatility has hugged a tight range for decades

Source: S&P

Suffice it to say, owning stocks is more fun when returns are high and volatility is low rather than the other way around. That risk-return trade-off is constantly in flux, and an easy way to track it is by measuring the ratio of return to volatility over time — a higher ratio indicating more buck for the bang, so to speak. That ratio was 1.3 during the last bull market, matched here again by only the big three bull runs in the last 150 years. Based on Vanguard’s return and volatility forecasts, investors can expect a ratio of between 0.1 and 0.3 from the S&P 500 over the next decade, which would rank among the lowest on record.

Getting Paid

Investors were well compensated for equity risk during the years between the financial crisis and coronavirus

Source: S&P


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