What is Reasonable for Clients to Expect from their Stocks?

I recently received an e-mail from a client asking about what minimum performance he should expect from his investments. With a few modifications, here is the gist of my reply…

Dear Mitch:

Thanks for your e-mail asking me whether it was reasonable to expect 10 percent per year growth in your investment portfolio.

Though historical data tells us that it is reasonable to hope your stock portfolios will grow at an average rate of 10 percent per year over the long term, it is unwise to count on that sort of growth.

What is reasonable to expect out of your investment portfolios depends on your perspective (relative vs. absolute) and how soon you plan to start spending money from the account.

If you favor a “relative” perspective, your goal might be to outperform whatever “index” of stocks you think sets the standard. The most commonly reported indexes are the “blue chip” indexes like the Dow Jones Industrial Average of S&P 500, which report the performance of the largest U.S. companies.

However, it is also valid to measure the success of your portfolios against broader groups of stocks – such as those including a much larger basket of publicly-traded U.S. stocks (e.g., the Russell 3000) and/or of the largest companies around the world (e.g., the Wilshire 5000).

In addition to deciding on a relative measure of success, you should also consider the “absolute” perspective. This view focuses on making sure your investment portfolio does not produce short-term breakdowns due to sharp swings in value and that it averages enough growth over the long term for you to live a good life.

This absolute measure of success, however, should differ depending on how soon you need your money.

In the short term (one to five years), absolute performance benchmarks should be focused on your unique cash flow and emotional factors, not on any fixed percentage.

From a cash flow standpoint, if you don’t plan to liquidate your investments in the foreseeable future, you might be able to afford a major short-term drop in the value of your investments. Emotionally, however, such a drop might produce more anxiety than you want to live with.

In a 100 percent stock account, you should expect that the value will drop significantly once every several years. According to Ibbotson Research, the U.S. blue chip market has endured 13 major declines (losing 10 percent to 44 percent in value from peak to trough) during the past sixty years – averaging a couple of bear markets each decade. Four of these bear markets have occurred in the past 18 years, including two in which the market dropped more than 30 percent.

The net effect of these historical facts is that I would be setting myself up to fail and encouraging my clients to live in fantasy if I suggested 10 percent growth was an appropriate measure of success in any particular calendar year. Since 1945, the United States blue chip market (as measured by the S&P 500) has either declined or risen less than 10% roughly a third of the time.

The longer-term story, however, is different. During the 50 10-year periods since 1945, the United States blue chip market has averaged more than 10 percent annual growth per year roughly three-quarters of the time.

But 10 percent average growth per year is still a dangerous figure to use – even in the long term.

First, it does not take into account the costs of taxes, trading or money management, which can easily knock from 2 to 4 percent off your gains. Second, many analysts are predicting lower long-term average annual returns in the future than we have enjoyed in the past, for a variety of reasons.

As a result, many others and I think it is imprudent to count on more than a 7 percent/year growth over the long term. I can send you some reading material on this if you like.

Of course, my company’s portfolio managers plan to exceed a long term average of 7 percent growth per year, but we cannot prudently guarantee it. The best long-term guarantee the United States government is willing to offer investors is only a little more than 4 percent per year. If we can double that for our clients after our fees are paid, we will be satisfied.

I hope this is helpful. Please let me know if you have any questions or concerns about the points I have made. With your help, I might turn it into one of my State Journal columns…

Best regards,