Many investors in today’s equity markets may find new meaning to John Lennon’s 1984 pop hit "Nobody Told Me." Market drubbings may lead ill-advised investors to worry unnecessarily and perhaps even act on that worry—much to their detriment.

As you likely know (but may be in need of a refresher), equity markets are expected to steadily rise in the long-run. They are also expected to bounce all over the place in the short-term. During times as those we have recently endured, it becomes critically important to remember that short-term volatility has little, if any, impact on long-term expected returns.

This important investing concept is at the heart of Burton Malkiel’s A Random Walk Down Wall Street. Originally inked in 1973, Malkiel’s timeless investing classic (now in its ninth edition) provides an important reminder to each of us that in order to be successful long-term investors, we must tune out the short-term noise.

There are moments, however, when tuning out noise can seem a monumental task.Tickers that scroll predominately red can erode an investor's staying power. This is when the most stoic and successful investors hunker down and recall the important investing concepts that are provided by 80 years of history and the academic research of unbiased financial experts. Three such concepts follow:

1) You get paid for risk

Risky investments, particularly small and value equities carry higher expected returns over time. They also carry higher short-term volatility expectations. Indeed, this is the price an investor must pay in order to achieve those higher long-term returns. 

The two charts below explain this increased volatility for increased reward concept. Figure 8-5 shows a distribution of 600 monthly returns of Index Portfolio 90, an all-equity portfolio which has achieved average monthly returns of 1.14% for 50 years. This portfolio also had a monthly standard deviation of 4.01% for that time period. Based on the average return and standard deviation of long-term historic data, a probability distribution of future outcomes can be estimated. In other words, we expect this Index Portfolio to achieve similar returns in the future but also carry a similar amount of volatility relative to an Index Portfolio with a more narrow range of volatility.

Figure 8-5

To that point, Figure 8-6 shows that Index Portfolio 30 has a more narrow range of monthly returns, but it also carries a lower expected return over time. Quite simply, investors cannot avoid risk and expect to earn returns above the risk-free rate.

Figure 8-6

(click to enlarge the charts)

Risk is the currency of return. A greater return is payment for investors subjecting themselves to greater uncertainty of those returns. Without the uncertainty of gain or loss, why would there be any logical reason for investors to earn money? This correlation is evident in virtually all stock market historical data.

2) Rolling Period Returns Can Provide Reassurance

A big obstacle for many investors is the high level of inaccuracy that comes from making decisions based on small samples of stock market data, or short-term market fluctuations. Rolling period returns data can go a long way toward solving this problem.

Rolling periods are created with monthly or annual data that overlap from one period to the next. Figure 8-9 illustrates how rolling periods are obtained using monthly frequency. As you can see Period #1 is the 12 years from January 1957 to December 31, 1968. Period #2 starts one month later on February 1, 1957 to January 31, 1969. Imagine this occurring 457 times over a 50 year period. This analysis helps capture the various experiences of 12-year investors who start their investments in July 1957, January 1963 or just about any month within the 50 years.

Figure 8-9

(click to enlarge the charts)

Table 8-1 is a rolling period analysis of Index Portfolio 100. (Similar information is available for each of IFA’s 20 Index Portfolios, and can be found by clicking here and choosing a portfolio.)

If you look at the red highlighted row in the figure below, you will see that it covers 12-year rolling periods (144 months each) and in the period from January 1958 to December 2007, there are 457 12-year rolling periods. As you read across the red highlighted row, you can see lots of interesting data about those rolling periods.

For example, you will see that for all annual periods shown, the average annualized return is about 14%. You will also see that the standard deviation of annualized returns of this Index Portfolio diversifies down to 3.95% when the Index Portfolio is held for the 12-year recommended holding period—a far cry from the 17.69% volatility number that exists for the 1-year period. This table further shows that the lowest rolling period return was for the 1/63-12/74 time period when the lowest average annualized return was 7.02% and a dollar invested during that time grew to $2.26. We also see that the highest rolling period return occurred from 1/75 to 12/86 when the average annualized return for that time was 24.24%,and a dollar invested during that period grew to $13.53. This type of information is invaluable for making important decisions, and for keeping you invested properly for the long term.

Table 8-1

(click to enlarge the charts)

3) Invest Right and Sit Tight

Certainly, many investors are currently lamenting “Nobody told me there’d be days like these.” IFA clients are likely NOT among them. Taking the important time to educate its more than 2,000 clients about risk, return and the impact of time on investments, IFA's clients are empowered to sit tight through market volatility, and to earn the long-term returns provided by an investment in capitalism.
 
If you would like to learn more about how you can invest right and sit tight, go to ifa.com, or simply call IFA to speak with an investment advisor representative, call 888-643-3133.

What do academics say about the relationship between economic conditions and expected investment returns?

1) Expected returns on bonds and stocks are higher when conditions are weak and lower when economic conditions are strong.
- Fama and French, "Business Conditions and Expected Returns on Stocks and Bonds," (November 1989), Journal of Financial Economics –

 2) The risk premium is expected to be countercyclical: lower in good times and higher in bad times.
- Campbell, J. and J. Cochrane (1999), By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior, Journal of Political Economy, Vol. 107, 205-251

This information has been furnished to you by Index Funds Advisors, Inc., a fee-only Independent Financial Advisor registered with the United States Securities and Exchange Commission. Please see www.ifa.com/btp for complete sources, updates and disclosures.

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