Lowering expectations for investors

If you ask a random retail investor about what normal stocks market returns are, you will often get this answer: “normal market returns are generally around 10% a year” or “if you invest in the stock market now, you can expect to gain 10% a year on average”. I think there are significant issues with these statements that, although may seem innocent, will cost you dearly if used as a foundation for your financial plans.

Having said that, two questions might come to mind: why do we have the myth that the stock market averages returns of 10% a year? And, if 10% is not a good average, what is the true stock market’s expected return?

The first question is fairly easy to answer; when people talk about the stock market, they usually only refer to the American one, often considering just one index: the S&P 500. It’s not hard to understand why, as the U.S. market is by far the largest, detaining around 50% of the world market capitalization; it’s the most popular and it has overperformed every other market in the last century. If someone believes that the whole stock market is merely made up of the U.S. market, then yes, stocks have returned around 10% per year on average, precisely 9.24% in the last 150 years and, if you look at the returns with a shorter and more recent time horizon, the returns get even better: the S&P 500 returned 11.30% in the last 50 years, 12.68% in the last 10 and 14.54% in the last 5. Now, that we like it or not, today’s investing culture comes from the United States: the most famous investors, TV channels, magazines, books and influencers are usually American. Moreover, it’s much easier to find data for the U.S. stock market compared to other countries: with a simple query you can have all the data you need at your fingertips, whereas we can’t really say that for other markets, especially the emerging ones.

Before moving on to the second question, I want to take a moment to explain why it’s so risky to assume that stocks return 10% a year on average. Firstly, by saying that the stock market returns 10% a year (or any other number really) some people – maybe beginners to the world of finance – might think that those returns are more consistent through time than what they actually are. Using the much beloved and easily accessible S&P 500 Index, do you know how many years between 1928 and 2023 (96 years in total) the index returned a value between 8% and 12%?

Only 5.

Yes, the “stock market” returned a value close to 10% in only 5 out of 96 years and, even by enlarging the return sample by a lot, the results are still shocking: the S&P 500 Index returned a value between 0% and 20% in only 34 out of 96 years. To add more context, during the 1928-2023 period the S&P 500 returned 9.90% on average – the worst year being 1931, when the index lost 43.34%, and the best one being 1933, when the index gained 53.99%. As you can see, even if the index did return close to 10% on average, the distribution of those returns is all over the place, and by a lot. Of course, this reasoning applies to all estimates of stock returns; still, it needed to be mentioned.

The second and most important reason why claims of “10% on average” are harmful is that if people relied on this unrealistic assumption, they’d end up making really bad financial plans and decisions. Thanks to compound interest, a change in returns of a couple percentage points would make a massive difference in the long term: just imagine setting up a retirement plan based on the “10% return” and, decades later, discovering that the actual return was slightly lower, thus shattering your retirement goals.

But why isn’t 10% a good estimate of expected returns and what could be a better one?

As I mentioned before, the U.S. market is not the whole market: a sensible investor will certainly create a portfolio that is well diversified across countries and regions, which will lower its expected return quite a bit. But if this is the case, why not just invest in the U.S. market? Well, even though the United States have the highest historical stock market returns, past performance does not guarantee future results. I can’t see the future, but I am pretty sure the next 150 years will not look like the last 150; no one can predict which country will dominate the stock market in the upcoming decades and if they tell you they can, they’re lying. Investing your whole portfolio in only one country is extremely risky, no matter how fantastic their past returns are.

After debunking some myths about the famous “10%”, let’s finally dive into the second question of today’s article. What is the stock market’s expected return going forward?

Estimating this value is no easy task. It requires considering a wide range of inputs and, even with the best effort, the result will always carry a lot of uncertainty. Typically, firms calculating this rate start by looking at a wide range of equity historical returns and then adjust for current market conditions. If we check out some of the reports published by these organizations, we can get a rough idea of the expected future returns of the stock market.

As you can see, each firm has quite different expectations about the stock market; still, they all seem to converge around a mean of 7%. Of course, this is nothing but an estimate and therefore should be taken with a grain of salt – nonetheless, it depicts reality far more accurately than the faulty 10% ever could.

I hope this article has demonstrated that a consistent 10% stock market return is a dangerous fairy tale, one that could lead people to make bad financial decisions. It’s time to swap myths for reality, and to adjust our expectations in order to thrive while planning our financial future as investors.