Why Historical S&P 500 Returns Can Be Misleading

Imagine trying to drive to a new city using only a map from twenty years ago. The main roads might still be there, but new highways could have been built, some smaller streets might have changed, and traffic patterns are definitely different. Using that old map would give you a general idea of the direction, but it wouldn’t be a perfectly accurate guide for your trip today. Thinking about historical average returns for an asset like the S&P 500 is somewhat similar to using that outdated map.

The historical average return of the S&P 500, which is simply the average of its past annual returns over a certain period, is often cited as a benchmark for expected future performance. It’s easy to calculate and seems straightforward. However, relying solely on this historical average to predict the future expected return can be quite misleading because the financial world is constantly evolving.

One major reason for this imprecision is that market conditions are never static. The economy goes through cycles of growth and recession. Interest rates fluctuate. Technological advancements disrupt industries. Global events, from political shifts to pandemics, can have significant and unpredictable impacts on the market. Think about it like the weather. Just because the average temperature in July has been a certain number for the past fifty years, doesn’t guarantee that next July will be exactly the same. Climate patterns shift, unexpected heatwaves or cold fronts can occur, and the actual experience can vary quite a bit from the long-term average. Similarly, the economic and market “climate” today is different from what it was ten, twenty, or fifty years ago. Factors like globalization, the rise of the internet, and changes in investor behavior all influence market returns in ways that might not be perfectly reflected in past averages.

Another important point is that historical averages are based on a limited sample of data. While we might have decades or even a century of S&P 500 returns, this is still a relatively short period in the grand scheme of economic history. Imagine flipping a coin ten times and getting heads seven times. The average result would be 70% heads. Does this mean the true probability of getting heads is 70%? Probably not. With a larger sample size, like flipping the coin a thousand times, the percentage of heads would likely get much closer to the true probability of 50%. Similarly, the historical average return of the S&P 500 is based on a finite number of years. Over longer stretches of time, or if we could somehow replay history with slightly different starting conditions, the average return could look quite different. This is because market returns are influenced by a multitude of random events and shocks, and any historical period is just one realization out of many possibilities.

Furthermore, the very concept of “expected return” is about the future, while historical averages are firmly rooted in the past. The expected return is what investors anticipate earning on average over the long run, considering all available information and future possibilities. It’s a forward-looking concept. Historical averages, on the other hand, are backward-looking. They tell us what did happen, not necessarily what will happen. While past performance can offer some insights, it’s not a guarantee of future results. Think of it like this: a baseball player’s batting average from last season is interesting, but it doesn’t perfectly predict their batting average for the upcoming season. Their skills might have changed, the opposing pitchers might be different, and luck will always play a role.

Finally, significant, unexpected events, often called “black swan” events, can dramatically skew historical averages and make them less reliable predictors. Events like major financial crises, global pandemics, or unforeseen geopolitical shocks can cause market returns to deviate significantly from their historical norms, both positively and negatively. These events are, by their nature, unpredictable and can have a lasting impact on market behavior. If a few extreme years are included in the historical average, they can disproportionately influence the overall average, making it less representative of what we might reasonably expect going forward in more typical market conditions.

In conclusion, while historical average returns can serve as a starting point for understanding the long-term performance of the S&P 500, they should be viewed with caution. They are imperfect estimates of the true expected return because market conditions are dynamic, historical data is limited, and unpredictable events can significantly alter market behavior. A more comprehensive approach to estimating expected returns would involve considering a wider range of factors, including current economic conditions, market valuations, and future growth prospects, rather than solely relying on past averages. Think of historical averages as a rough compass, useful for getting a general sense of direction, but not precise enough to guarantee you’ll reach your destination without considering the ever-changing landscape around you.