Long-Term Stock Returns: Why History Matters

Imagine you’re trying to predict the weather, but you only look out the window for five minutes each day. Some days, it might be sunny during your five-minute observation, leading you to believe it’s always sunny. Other days, it might be raining, making you think it’s perpetually wet. You’d get a very skewed and unreliable picture of the overall climate, wouldn’t you?

The stock market is a bit like the weather in this analogy, and historical returns are like weather observations. If we only look at short periods of stock market history, say just a few years, we can easily be misled. Stock markets are inherently volatile, meaning their returns jump up and down quite a bit in the short term. Think of it like a rollercoaster – sometimes you’re soaring high, and other times you’re plunging down.

In any short period, say five years, you might experience a fantastic bull market, where stock prices are constantly rising. If you based your expectations solely on this short, positive period, you might think that stocks always deliver incredibly high returns. You’d be tempted to put all your money in, expecting continuous riches. Conversely, you might pick a five-year period that includes a major market crash, like the financial crisis of 2008. Looking at just that period, you might conclude that stocks are incredibly risky and always lose money. You might decide to avoid stocks altogether, missing out on potential long-term growth.

The problem with short periods is that they are heavily influenced by specific events, good or bad, that might be temporary or unusual. These short-term fluctuations are essentially noise. To get a clearer picture of the underlying trend, the true average return of stocks, we need to look at a much longer timeframe.

Think about flipping a coin. If you flip a coin just ten times, you might get heads seven times and tails only three times. Based on this small sample, you might incorrectly conclude that the coin is biased towards heads. However, if you flip the coin a thousand times, you’ll find that the ratio of heads to tails gets much closer to 50/50. The more flips you do, the more the randomness evens out, and you get closer to the true probability of a fair coin, which is 50% heads and 50% tails.

Historical stock market returns work similarly. Over very long periods, like fifty years, seventy-five years, or even a century, the ups and downs, the booms and busts, the periods of high growth and slow growth, all tend to average out. Exceptional short-term events, whether positive or negative, become less dominant in the overall picture when you zoom out to a longer timeframe.

By looking at these extended periods, we can smooth out the short-term volatility and get a more stable and reliable estimate of the average return we can realistically expect from stocks over the long haul. This long-term average is a much more meaningful number for planning things like retirement savings or long-term financial goals. It gives us a better sense of the typical performance of stocks, stripped away from the noise of short-term market swings and specific historical anomalies.

So, while a five or ten-year snapshot might tell a compelling story, it’s often an incomplete and potentially misleading one. To understand the true nature of stock market returns and get a reasonable estimate of what to expect on average, we need to take the long view and examine returns over many decades, just like observing weather patterns over many years to understand the climate rather than just a few days. This longer perspective helps us see the forest for the trees, revealing the underlying trend amidst the daily fluctuations.