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Getting to the heart of long-term investment returns

John Bogle, the founder and former CEO of Vanguard, uses just three charts to illuminate 100 years of market history and demonstrate some fundamental truths about investment returns.

He manages to separate what matters from what doesn’t in the long run. Economic fundamentals drive long-term returns; volatile price swings based on investors’ emotions do not.

Start by looking at the total return of the S&P 500 over the past 100+ years. Total returns averaged 9.6 percent, but notice how significantly they varied from decade to decade — a spread of over 20 percent from the highest to lowest performing decade. Notably, every decade except the 1930s and 2000s experienced a positive return. The 2000s finished with a total market return of approximately -1 percent.

Virtually all of the market return over the past 100 years comes from what Mr. Bogle refers to as investment return as distinguished from speculative return. Investment return is derived from two components: the initial dividend yield for the period measured (here, in decade increments) and subsequent growth in earnings. Over the past 100 years the investment return from these two components averaged 9.5 percent.

So, the total market return was 9.6 percent while the investment return was 9.5 percent. Where did the remaining .1 percent come from? The difference is what Bogle refers to as speculative return. Speculative return is driven by increases or decreases in the price/earnings ratio or P/E. Essentially, the P/E rises or falls as investors’ expectations for the market rises or falls.

The stunning observation by Bogle is how the impact of a rising or falling P/E can be so significant over shorter periods, even over a decade, but matter so little over the long run. In the 1980s and 1990s the additional boost from a rising P/E was huge and also unusual in that it continued for two consecutive decades. In the 2000s, however, we paid the price as the P/E trended downward toward the historical norm, wiping out any positive impact from investment returns.

Speculative return — the increase or decrease in the P/E ratio — is driven by investor emotion. In the 1990s, investors’ “irrational exuberance” pushed market prices to all time highs, but in the 2000s uncertainty and despair manifested themselves in two massive market corrections.

Note the lack of consistency in the speculative returns. The impact of P/E change was negative in five out of eleven decades. It ranged from a positive impact of 9.3 percent in the 1950s to a negative impact of -8 percent in the 2000s.

By comparison, investment returns have been much more consistent. Dividends have ranged from 3 percent to 7 percent and have always been positive. Earnings growth has ranged from 4 percent to 7 percent and has always been positive, except for the 1930s.

How is this relevant to investors? It reaffirms the overriding importance of a sound strategy based on asset allocation and capturing investment returns as efficiently as possible.

First, recognize that a rising or falling P/E is, at least in part, a measure of the collective emotions of investors. Short-term swings in investors’ emotions are not predictable, however, and should not be a basis for making investment decisions.

Second, the impact of what Bogle calls speculative return may be significant over the short-term, but matters little in the long run. Therefore, don’t chase it.

Third, in the long run economic fundamentals, not investors’ emotions, drive market returns. So, when emotions have pushed market prices too far in one direction or the other, intelligent investors should expect the inevitable reversion to the norm and rebalance to maintain a long-term strategic allocation.

David Peartree, JD, CFP® is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, N.Y. 14625; email david@worthconsidering.com.

About David Peartree