The average return doesn’t exist (2020 edition)

Here’s this year’s update of the ‘average return doesn’t exist’ blog showing that the average return on equities is mostly a statistic, and is seldomly seen in reality. And last year is another brilliant example of that. The Dow Jones Industrial Average realized a a positive return of more than 22% in 2019, miles away from the average return of 7.4% since 1900. It also underpins that using this long-term average for forecasting annual returns, as many professional forecasters tend to do, will do little good for your ‘guru’ status. Those who dare to put in ‘obviously’ far too bearish or far too bullish forecasts have (much) better odds in getting it right.

The graph below shows the calendar year returns on the Dow Jones Industrial Average Index since 1900, ranked from lowest (left) to highest (right). During this period, the calendar year return on the Dow Jones has averaged 7.4%. From this perspective, a return forecast of let’s say somewhere between 5 to 10% doesn’t sound that crazy. You take some safety margin around the long-term average and you’re probably good, right?

Wrong! A forecast like the one above is naive. If we zoom in on the graph, it reveals that, since 1900, the return on the Dow Jones has been between 5-10% in just ten occasions (the black bars). That’s not that often given the time span of 120 years. The Dow Jones return comes in the 5-10% bracket roughly 8% of the time, or just in one out of every 12 years! Conclusion: ‘Gurus’ forecasting a return of between 5-10% would have got it wrong most of the time.

Eternal optimists and ultra bears

Instead, you would have been much more successful by predicting a return of 20% or more for every single calendar year. In no less than 32 (including the 2019 return) out of the 120 years since 1900, the Dow Jones generated a 20%+ return. This, ‘overly’ optimistic view on the stock market, has a success rate of 26%(!), more than three times higher than the success rate of the conservative 5 to 10% return forecast.

And what about the ultra bears? They too beat the ‘stick with the average’ forecasters. Pessimists, who dared to predict a negative return of 20% or more for every single calendar year, got it right in eleven out of 120 years since 1900. Still one more than forecasters predicting a return between 5-10%.

If anything, the statistics above show that the number of ‘doomsayers’ and ‘eternal optimists’ in the market is probably too low, instead of too high. Too few forecasters take the historical return distribution into account and bet on massive equity rallies or heavy losses. Perhaps there is some logic behind it. Because who has the ability to forecast the Dow Jones for 120 years? But more importantly, predicting a bull market in a year when stock prices collapse is probably a bit too damaging for your guru status.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s