The S&P 500 has trained a generation of investors to expect the extraordinary
For much of the past 15 years, one of the simplest investment strategies has also been one of the most successful: buy the S&P 500 and hold it.
The results have been impressive enough to shape an entire generation's expectations about investing. Double-digit annual returns have come to seem achievable, prolonged downturns have appeared temporary, and buying market declines has been rewarded frequently.
How would your portfolio fare if the market stopped behaving the way you've come to expect?
Is a 10% annual return really normal?
The S&P 500's long-term historical average annual return is often cited at approximately 10%, including reinvested dividends[1]. That figure has become a familiar benchmark for retirement planning, investment projections, and comparisons with other assets.
However, the average conceals enormous variation.
From 2000 through 2009, the S&P 500 delivered a negative annualized total return, despite two substantial bull markets during the decade[1]. Investors who entered the market near the beginning of that period waited years to recover their losses.
The following decade offered a dramatically different experience. From 2010 through 2019, the index generated annualized total returns of approximately 13.6%, including dividends[2].
An investor whose experience began during the second period could reasonably develop very different expectations from someone who started during the first.
Both experienced the same stock market, but their understanding of its risks and rewards depended heavily on when they began investing.
The conditions behind an extraordinary bull market
Following the global financial crisis, several favorable conditions helped drive strong U.S. equity returns.
Interest rates remained exceptionally low for much of the 2010s, reducing borrowing costs and making future corporate earnings more valuable in present-value terms[3]. The Federal Reserve also purchased substantial quantities of financial assets, supporting liquidity and influencing financial conditions[4].
Large technology companies gained influence within the S&P 500 as they generated substantial profits without requiring comparable increases in physical capital investment.
Their growth helped drive index returns, while rising valuations amplified the gains.
Globalization, corporate profitability, and the expansion of profit margins also contributed to the favorable environment.
These developments produced genuine economic value, but they also created conditions that may be difficult to reproduce indefinitely.
Strong business performance helped drive returns higher. Rising valuations amplified those gains, creating another source of returns that may prove difficult to sustain.
What happens when valuations stop rising?
Generally, stock market returns come from three sources[5]:
- Earnings growth
- Dividends
- Changes in valuation
The third component deserves particular attention. When investors become willing to pay more for each dollar of corporate earnings, stock prices can rise faster than the underlying businesses grow.
For example:
- Suppose a company earns $10 per share and trades at 15 times earnings. Its share price is $150.
- If earnings increase to $12 while the valuation multiple expands to 25, the share price rises to $300.
- The company's earnings increased 20%, while its stock price doubled.
Such gains can persist across an entire market when valuations rise over an extended period. However, as valuation multiples expand, they become increasingly difficult to justify.
Consequently, future returns may depend on earnings growth and dividends to a greater extent than investors have experienced in recent years.
If valuations contract, the market can produce strong corporate profits and deliver disappointing returns at the same time.
The market doesn't have to crash to disappoint you
Historical averages can provide useful context, but they can't establish what the next decade will deliver.
People who assume recent performance represents a dependable baseline may underestimate the consequences of:
- Lower returns
- Longer recovery periods
- A sustained decline in valuations
The danger extends beyond financial projections. Expectations influence behavior, including how much volatility people tolerate and how they respond when markets fail to deliver familiar results.
A return to ordinary performance may be enough to expose just how unrealistic expectations have become. What could this mean for the risks within a conventional portfolio?
The former head of ETF trading at Lehman Brothers, Jared Dillian, joined The Gold Exchange Podcast to explore why traditional investment strategies may carry more risk than many realize. Watch now to discover why managing volatility may matter as much as pursuing higher returns.
Sources:
- https://www.dimensional.com/us-en/insights/a-tale-of-two-decades
- https://equitycompass.com/content/Insights/content/hagstrom_2019-fourth-quarter-commentary.pdf
- https://www.federalreserve.gov/publications/may-2021-asset-valuations.htm
- https://www.newyorkfed.org/markets/programs-archive/large-scale-asset-purchases
- https://www.lseg.com/en/insights/ftse-russell/decomposition-of-us-equity-returns-over-time-is-it-different-this-time