What is Normal Return?

I been wanting to write this post for sometime and finally got to do it today. We have seen turbulent economic conditions for the last few years that have brought returns which doesn’t really match any previous years. It brings to us a big question, What is the Normal Return?. Here is a snapshot of an article published TRoweprice analyst last year.

What is the Normal Return?

There may not be a right answer. When looking at short-term holding periods, such as one year, it has been normal for the market to have ‘abnormal’ returns. With extreme total returns of -37% in 2008 and about 26.5% in 2009—as measured by the S&P 500 Index—even the most steadfast investors may have struggled with their emotions. The S&P 500 Index is comprised of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe.

However, 2010’s return of 15.06% was closer to the index’s historical annualized return since 1926 of 9.87%. Is that a more typical year? Indeed, how should investors evaluate their returns?

While the future isn’t predictable, past returns can offer some insights. Consider the chart on this page, which shows the distribution of the S&P 500 Index’s annual total returns since 1926.

A quick glance shows how infrequently the market has declined more than 10% in a year. More evident, though, is that the market returned more than 10% in 48 out of the last 85 years, or more than 56% of the years.

While there is a wide variation of returns, the years in which returns were positive by 10% or more have been much more common than any other outcome.

If the market volatility of the last few years has made investors question their investment strategies, they, likely, are not alone.

How to Avoid making changes during this unstable periods?
Investors may want to take into account this long-term pattern of returns when they are questioning their asset allocation decisions after a year of underperformance. When returns are low or negative, it’s natural to feel that you have to act, but action isn’t always in favor of the investor. Changing an asset allocation decision based solely on the returns of 2008 is just as irrelevant as changing your asset allocation based solely on the returns of 2009. You have to step back and put your portfolio in the context of long-term returns.

Emotional Reactions to Volatility Is Our Worst Enemy
Emotional reactions to market volatility can be investors’ worst enemy. Having a well thought out investment strategy is the first step to conquering the ups and downs of the market.

In conclusion, don’t focus more on the last year’s return, investors in stocks and stock funds may do better making their investment decisions based on their risk tolerance and the time horizon of their financial goals. You can check out my last blog posted about How Risk Tolerance and Time Horizon plays key role in your investment goals.

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