The average return doesn’t exist (2021 edition)

Welcome to this year’s update of the ‘average return doesn’t exist’ blog, revealing that the average return on equities is mostly a statistic, and is rarely seen in reality. However, paradoxically as it may seem, it is 2020, one of the most extraordinary and volatile years in history, which shows that the average return has not become extinct. The return on the Dow Jones Industrial Average for 2020 measures 7.2%, just a whisker below the average return of 7.4% since 1900. 

Even though last year’s return was close to the long-term average, historical data show that using this long-term average for forecasting annual returns comes with a low probability of getting it right. Those who dare to put in ‘obviously’ far too bullish forecasts have much better odds in getting it right. In addition, ultra bears estimating negative returns of 20% or worse, do not underperform ‘average return’ forecasts.

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! Well, at least most of the time. 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 11 occasions (the black bars). That’s not that often given the time span of 121 years. The Dow Jones return comes in the 5-10% bracket roughly 9% of the time, or just in one out of every 11 years! Conclusion: forecasting a calendar year return of between 5-10% will prove inaccurate 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 out of the 121 years since 1900, the Dow Jones generated a 20%+ return. This, ‘overly’ optimistic view on the stock market, has a success rate of 26%(!), three times higher than the success rate of the conservative 5 to 10% return forecast.

And what about the ultra bears? They don’t do worse than ‘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 11 out of 121 years since 1900 as well. Obviously, forecasting such a bearish return is better remembered.

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. Where does that leave me? I expect double digit returns for 2021, likely 15% of higher, giving me a 35% probability to get it right.

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