One of the most common questions I get asked by friends and family is "How much should I expect my stocks to go up each year?"
Simply put, this is the wrong question to ask. A better question is "How much should I expect my stocks to return over the next few decades?" Here's why it's relatively easy to predict what the stock market will do over long periods of time, but next to impossible to anticipate what it will do in any given year.
Over the long run, the answer is easy
Although the stock market has not moved in a straight line, over time the returns it has generated have been surprisingly consistent. Over long periods of time, the major indexes have generated annualized total returns of 9%-10%, varying slightly depending on the exact time period you're looking at.
For example, since 1965, the S&P 500 has produced total returns (including dividends) of 9.7% annualized. Over the past 100 years, the Dow Jones Industrial Average has risen by an average of 5.8%, which when you add in dividends that have historically been in the 3%-4% ballpark, the total return is in the 9%-10% range.
In other words, if you invest in a well-diversified stock portfolio, it's reasonable to expect 9% annualized total returns from your stock investments over the long run.
In any given year, it's far more complicated
While the stock market is quite consistent over long time periods, the exact opposite is true over shorter intervals. Over the past 50 years, the S&P 500 has returned as much as 37.2% in a single year and has lost as much as 37%.
To put some numbers behind the "What should you expect?" question, bear with me while I briefly dive into a couple of mathematical concepts.
First, while the cumulative annualized total return of the S&P 500 has been 9.7% since 1965, the mathematical average return in any given year has been 11.2%. Without going into too much detail, the reason for this is that negative numbers have a greater effect on a cumulative return than positive years do.
The standard deviation of the S&P 500's annual return over the past 50 years is 17%. If you don't know what standard deviation means, that's fine. The important concept is that a statistical definition of "usual" is being within two standard deviations of the average, or within 34% in this case
Here's the point: A quick addition and subtraction tells us that the range of "usual" stock market returns in any given year is from -22.8% to +45.2%. In other words, any annual performance within these two thresholds would not be considered unusual. This means that the stock market could rise by 40% in 2018, drop by 20% in 2019, and rise by another 35% in 2020, and none of this would be considered to be unusually volatile -- at least from a mathematical perspective.
As a final mathematical concept, by definition, "unusual" events happen about 5% of the time. This means that in 5% of years, or one in 20, you can expect the market's performance to be outside of the range I just mentioned. Unusual performance has occurred twice since 1965, both times to the negative side.
The bottom line is that while over time the stock market has been a consistent moneymaker for long-term investors, it can be extremely volatile over short time periods. In fact, you should expect volatility in any given year, month, or week.
Because of this, many experts suggest that you shouldn't invest any money in stocks that you're going to need within the next five years, and I believe this might even be too conservative. Stocks are a long-term investment, and you should keep this in mind when deciding how to allocate your capital.
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