Stock market performance is difficult to forecast, but understanding what to expect is really important for anyone that’s relying on their investments to help them reach their goals. This essay summarizes a twenty-five minute video we recently posted on our YouTube channel. If you’d like to explore this topic in a little more detail, we suggest giving it a watch!
The stock market is… complicated.
But despite that, it is possible to construct useful understandings of how it behaves through careful study of its long-term performance.
Before we get into that though, let’s make sure we share a functional understanding of what we’re talking about. Feel free to skip ahead if things get a little too basic for you, but we want to make sure that everyone’s able to follow along.
So let’s start at the very beginning.
What is a stock?
Happily, we have a euphonic case study that should help you understand this!
Consider Crocs, the rubber clog company.
At some point in their history, the founders realized that they needed more money in order to manufacture their products. This is a very common situation and can happen to any company whether it’s small or large.
Crocs’ financial position is summarized by something called a balance sheet, which records all of its assets and liabilities at a given point in time. Assets are things they own, like ideas, resources, or physical inventory, while liabilities are best understood as the way those assets are paid for.
As you might guess from the word “balance,” the general idea of these reports is that both sides should sum to the same value. The table below might be a helpful representation of this if you happen to be visually inclined.
|Tangible (Equipment, inventory, etc)||Borrowed money (mortgages, loans, bonds, etc)|
|Intangible (Designs, copyrights, etc)||Equity (often synonymous with “stock”)|
Investors are best understood as providers of capital to companies. We have two primary ways of charging the company to use our money: lending it to them through a loan or a bond and investing alongside them as stockholders.
How are Stocks and Bonds Different?
The main difference between them is that the return on stock investments is vague and uncertain while the returns that lenders like bond investors experience are generally determined (or at least well described) by a contract.
If the company were to encounter financial hardship or – in an extreme (but illustrative) case – enter liquidation, bondholders would be significantly better protected from financial loss than their stockholder neighbors on the balance sheet. Bondholders generally receive the interest and principal payments they are owed before stockholders get anything in these sorts of adverse situations.
With that said, if the fortunes of the business were to improve, a bondholder’s best case would be to get paid back in full. By contrast, stockholders would participate directly and proportionally in the improving fortunes of the company.
These stylized examples don’t capture the full spectrum of how these securities interact, but they do convey a few things that are important for long-term investors to internalize:
- We can use both stocks and bonds to charge companies for the use of our money,
- Bonds have a predetemined payoff, and
- Stocks have an uncertain payoff.
How does a Stock Portfolio Typically Perform?
This is where the fun really begins!
As a practical matter, it is very difficult to forecast the future of any particular company with much precision. We may love our crocs (and be wearing them as we write this essay) but that doesn’t mean we can see the company’s future clearly.
But when we combine individual stocks into a well-constructed portfolio, things get much easier to predict. Imagine that you purchased shares in the S&P 500 index, which is among the most widely used and studied indices, back in 1980. If you were to fall asleep for the next twenty years, you would probably have been very pleasantly surprised when you woke up and checked your brokerage statement.
To give you a sense of how good that surprise would be, we’ve excerpted the chart below from an excellent review of risk management practices published by Sloane’s former colleagues at the CFA Institute Research Foundation. This shows the market’s returns on a logarithmic scale, which shows exponential growth much more clearly than the linear charts you might be more familiar with.
You don’t have to worry too much about those math words though: we’ve included this chart to convey that there is a clear pattern of gradual ascent in long-term stock returns. Just look how the line goes from bottom left to top right!
So, if stock market returns are historically consistent, why is the stock market risky?
One could easily write a PhD thesis on this topic, and many people have. It’s complicated! But our goal in this essay is to leave you with a well-grounded understanding of how stocks behave, and it’s possible to get there without resorting to pursuing a graduate degree.
If you look at the chart above, you can see that returns oscillated between flat and negative for more than a decade after the year 2000. The 1970s were similarly non-wonderful times to own stocks. These things have happened, and likely will happen again!
But the important thing to remember is that they also usually stop happening eventually. And when they do, stocks’ long-term tendency to appreciate has historically returned in force. So there are significant practical rewards to adopting a patient posture that embraces this reality.
That’s true in triplicate when you zoom in to consider what might happen in any given year. The chart below shows that the S&P 500 Index – the same one we examined above – has declined an average of 14.3% at some point in each of the last 43 years.
Those declines are shown in red on the chart below, but they’re only half of the story. The grey bars on the same chart show the returns for each full year. And despite some sort of decline occurring like clockwork every single year, the stock market managed to notch a positive performance almost three quarters of the time.
At this point, it’s probably beginning to make a lot of sense why stocks are usually seen of the cornerstone of a long-term investment portfolio: if you can ignore, indulge, or otherwise plan for their volatility, they have an extremely well-documented tendency to turn money into more money.
We’ll get back to bonds in a second, but before we go there, let’s just lay out what we learned in this section:
- Stocks go down at some point every single year.
- They still managed to finish the year up about 75% of the time.
- To capture these returns, stay invested!
But is this really all that different from the way bonds behave? After all, many people we talk to aren’t particularly motivated by extracting every last iota of investment return from the market. They just want to live their lives with a reasonable sense that when they need money sometime in the future, there will be enough of it.
How do Stocks Compare to Bonds and Other Assets?
The book Stocks for the Long Run by Wharton professor Jeremy J. Siegel is perhaps the most widely referenced study of long-term investment returns. It’s worth a read for anyone serious about learning the craft of investing, but we bring it up here mostly because it also contains the excellent chart below.
This chart shows something remarkable in stark clarity: increasing our holding period decreases our range of outcomes.
Over the period Siegel studied – which begins in 1802 – stock performance was extremely variable in the short term. An investor who held a diversified stock portfolio for one year at any point during those centuries might have experienced a gain as large as 67%, a decline as stark as 39%, or anything in between those two values.
But as we move our eyes across the chart to the right and examine a longer holding period, the difference between the best and worst return narrows significantly.
After thirty years, the difference between the best and worst annualized return was only about 8%. So even if you were to pick the literal worst time in the past two centuries to put money into the stock market, there is a strong statistical argument that you would come out ahead with enough patience, planning, and preparedness.
Should I Expect Similar Returns from an Invest Vegan Portfolio?
We hate to conclude a fact-laden exploration like this with uncertainty, but it bears mentioning that the way we invest is nothing if not unusual.
We are proud of this, and it’s not going to change.
The people who are best suited to working with us are generally unsettled by the thought of investing in an index like the S&P 500, which contains (among other things) many prolific carbon emitters, weapons manufacturers, and organizers of industrial-scale animal slaughter.
We’d rather be punched in the face than have any involvement with those activities.
As a practical matter, a lot of our time is spent trying to insulate the portfolios we manage from an ever-growing list of product and conduct-based issues. In our view, this is likely to mitigate risk and promote adherence to our process, which has remained remarkably consistent since Sloane founded Invest Vegan in 2021.
But again, we do things differently around here. If the thought of your portfolio behaving differently from your neighbor’s is scary to you, it’s likely you will be better off working with a different firm. If that thought makes you queasy, it’s probably worth evaluating our strategies or scheduling a conversation with us.
But whether we work together or not, we hope we’ve helped you figure out how the stock market fits into your long-term plans. If you’re interested in receiving more resources like this, honest observations, and pictures of our cats once every full moon, you should subscribe to our newsletter.