The Three Factors That Affect Your Stock Return

Beyond Buy-and-Hold #89

We live in the greatest time in history to be stock investors. Why? Because it is so darn simple to a highly effective stock investor today.

In the days before index funds, investing was a complicated business. To do the job right, you had to study annual reports and Value Line and all sorts of other stuff to succeed. Not today. In the era of the index fund, there are three factors and three factors only that determine your stock return. Spend a tiny bit of time bringing yourself up to speed on those three, and you’re set for life.

Factor One: the likely long-term return for the index fund you invest in

You don’t want to invest in a fund that is going to provide poor long-term returns. The funds that provide strong long-term returns are so much more appealing!

I’m teasing. But there is a serious point to be made here. You really do want an index fund that is going to provide a strong long-term returns. The silly part in what I said above is the suggestion that it’s easy to know in advance which fund is going to provide a strong long-term return. Still, the full reality is — It IS pretty darn easy to know.

The S&P Index has been providing a long-term return of 6.5 percent real for 140 years. That’s a pretty darn strong indication that a return of something in that neighborhood is going to apply on a going-forward basis. Could it be that we have seen our best days and the return on a going-forward basis is going to be only 6 percent? Sure. Could it be that we are about to enter our golden age and that the return on a going-forward basis is going to be 7 percent? Sure.

Does it matter that much?

Invest in a broad U.S. index fund and you are going to earn something in the general neighborhood of 6.5 percent real. That tells you what you need to know. It’s a super return. So invest in a broad U.S. index fund.

You might do a bit better investing in an emerging markets fund. But guess what? You might not. You might do a bit worse. You might even do a lot worse. The U.S. economy is a mature and stable and yet also a dynamic economy. The 6.5 percent return is as close to a lock as you are going to get in this field. And it’s a return good enough to finance a middle-class retirement at a reasonable age. Stop asking questions. Invest in a broad U.S. index fund.

Okay, that one’s settled. There are still two more factors that affect your return that you need to take into consideration.

Factor Two: The PE10 Level

The most important factor is the valuation level (the P/E10 level) that applies on the day you purchase the fund. If you pay three times what the index fund is worth, the underlying business may generate enough earnings to support a 6 percent return but your return is only 2 percent. That won’t get you to a secure retirement in the time you have to get there.

The valuations factor is by far the most important of the three factors. The reason is that it is the only one of the three factors under your control. There’s nothing you can do to affect the productivity of the U.S. economy (the first factor) or the returns sequence that happens to pop up for you (the third factor). But you have the ability to change your stock allocation in response to big price changes and thereby get the valuations factor working to your advantage.

Factor Three: The returns sequence

The third factor that affects your stock return is the returns sequence that happens to pop up. I don’t discuss this factor nearly as much as I discuss the valuations factor because you cannot influence the returns sequence. But it is a significant factor and you do need to understand how it operates to increase or diminish your return.

When I tell people that long-term stock returns are predictable in the age of index funds, they often challenge me to give precise predictions. That I cannot do. The reason why is that, while the valuation level that applies when an index fund purchase is made tells us the range of possible returns that applies, the returns sequence determines the precise return and the returns sequence that will apply is not known in advance.

You can get a good idea for how the two factors interact by spending some time with The Stock-Return Predictor. The range of possible returns for an index fund purchase made today is 12 percentage points, the worst possibility being an annualized return of a negative 3.79 percent and the best being an annualized return of 8.21 percent. Yikes! That’s a big range! Maybe this business of predicting long-term returns doesn’t work so well after all.

Why it works

No, it works. You can cut that range in half by excluding the outlier possibilities on both the high and the low end. We can say that there’s an 80 percent chance that your return is going to be better than a negative 0.79 and an 80 percent chance that your return is going to be worse than 5.21. The range is now down to six points.

We can reduce it further by going out 20 years rather than 10 years. At 20 years out, there’s an 80 percent chance that your annualized return will be greater than 1.36 real and an 80 percent chance that it will be worse than 5.36 real. That’s a range of only 4 percentage points. A range that narrow gives us the ability to make remarkably precise return predictions.

The factor that determines which return in the range of possibilities will apply for you is the returns sequence. This is a luck factor—there is nothing you can do about it. So you are better off spending your time coming to understand valuations and how you need to change your allocation to keep your risk profile roughly constant. But you want to be aware of this factor so that you will understand why you obtained a return better or worse than the precisely most likely one, which of course turns up rarely.

Believe it or not, Rob Bennett thinks that saving for retirement is a bad idea. His bio is here. For background on the Big Fail of Buy-and-Hold and on the need to move to Valuation-Informed Indexing, please check out the “About” page at the “A Rich Life” blog.

( Photo from Flickr by Helico )

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