January 17, 2012


Lessons From 2011

ONE– Stock market returns are seldom what we expect.
The S&P 500 index was up 2% for the year, after being up 8% at the end of April and down 12% at the beginning of October.  Large stocks did better (Dow up 7%); small stocks did worse (Russell 2000 down 4%); and international stocks did much worse (EAFE down 12%).

It is unusual for the S&P 500 to move so little from one year to the next, but it is also unusual for it to behave the way we “expect” it to behave.  Since 1926 the average annual return has been about 11%, and yet over those 86 years, the annual return has fallen between 8% and 13% only 6 times.  The range has been -43% to +54%.

TWO – Regardless of the returns we realize, markets are volatile. 
In other words, we often experience the risk without realizing the commensurate level of return.

2011 certainly felt like a rollercoaster, and the stock market was indeed volatile.  Yet was that volatility unusual considering world economic events?  The experts at Vanguard say no, and provide evidence in a recent paper.  Their evidence is based on a comparison of economic volatility and market volatility, which turn out to be closely correlated.  Moreover, they show that the volatility of the economy and markets was higher in the 1970’s than it has been over the past five years.  Risk and return are related, but we only observe the correlation in the long run.

THREE– When “everyone agrees” on the likely direction of a market (or prices, or interest rates) they can still be wrong.
At the beginning of 2011 “everyone agreed” that interest rates had to rise from current levels.  Bill Gross was one prominent expert who put his money where his mouth was, declaring that U.S. Treasury yields were so low they did not adequately compensate investors.  He sold Treasuries out of his portfolio.  It turned out to be a spectacularly bad decision as Treasury rates fell further and his fund, PIMCO Total Return, the largest bond fund in the world, underperformed.

What is a reasonable range of expected returns…
We have all read the standard performance disclaimer, “Past performance is no guarantee of future returns.”  That warning has rarely been more important or relevant than it is today.

Bond returns have now outperformed stocks over the past ten years.  Mutual fund investors continue to pour money into bond funds in response to stock market volatility and, we assume, in part because of attractive past returns.

Vanguard published a paper in November 2011 that tried to answer the question, “What is a reasonable range of expected returns for a balanced portfolio of stocks and bonds based on present market conditions?”  For the full paper, click here:

They present several interesting conclusions including:

•  Expected returns for a 50% stock/50% bond portfolio are 4.5% to 6.5% nominal and 3.5% to 4.5% in real terms (after adjusting for inflation).  This result is modestly below the average since 1926 (8.2% nominal and 5.1% real) but better than the past decade.

•  Expectations for the next decade are driven by the current level of bond yields, which are highly correlated with future annualized returns from bonds.

•  The chart below shows expected returns for a more risky portfolio (80% stocks/20% bonds) more consistent with the historical average while the expectation for a less risky portfolio (20% stocks/80% bonds) less likely to achieve historical results.

Real (inflation-adjusted) returns







Notes:   Percentile distributions are determined based on results from the Vanguard Capital Markets Model.  For each portfolio allocation, 10,000 simulation paths for U.S. equities and bonds are combined, and the 10th, 90th, 25th, and 75th percentiles of return results are shown in the box and whisker diagrams.  The dots indicating U.S. historical returns for 1926-2010 and 2000-2010 represent equity and bond market annualized returns over these periods.  The equity returns represent a blend of 70% U.S. equities and 30% international equities; bond returns represent U.S. bonds only.

Sources:  Barclays Capital, Thomson Reuters Datastream, and Vanguard calculations, including VCMM simulations, and index returns.

•  With ten-year Treasury rates below 2%, it is irrational to expect bond returns over the next decade to be anything like the past decade, and nearly impossible mathematically.

•  Stocks, on the other hand, appear reasonably priced, capable of providing average historical returns, and quite likely to do better than the past decade, which began with stocks very highly valued (Price/Earnings ratios well above historical averages.)


1.  Expect returns from balanced portfolios to be below historical averages over the next decade due primarily to low bond yields.

2.  The incentive to take stock market risk (relative to bonds and cash) may be as high as it has ever been.

3.  Chasing the bond returns we have seen over the past decade is ill-advised.

4.  Taking more stock market risk may be tempting, but comes with greater volatility.

5.  Most investors should stay the course, with a balanced portfolio that reflects their long-term tolerance for risk.

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