- Over time, different types of investments, or asset classes, have generated different returns. Stocks have higher returns than bonds. Small cap stocks have higher returns than large cap stocks. Long-maturity Treasury bonds have higher returns than short-maturity Treasury bills.
- Asset classes with higher returns over the long term have tended to have returns that move around more over the short term, which is to say they have more volatility.
- You need to think about expected returns and the likelihood of actually achieving those returns over the specific time frame you have to reach any financial goal.
- The longer the time frame you have to work with, the greater the likelihood of actually realizing these expected returns, in which case volatility become increasingly irrelevant.
- When you have sufficient time frame, take advantage of it!
You always want to stretch your dollar. When you’re shopping you want to get the most you can or the best you can for each dollar you spend. In investing, you likewise want your savings to work as hard as possible for you, which is to say to generate the highest return. But in investing, given the future is uncertain (i.e. risky, as we just discussed), you have the added concern of minimizing the possibility of a bad outcome. So, the reasonable questions to ask are: 1) are there types of investments that offer higher returns, and 2) is there a good chance that we in fact realize those returns? We will see that time frame is the critical factor in answering both these questions.
Before I begin, I need to acknowledge up front that I base these perspectives on the historical record. If you’ve glanced at any investment product marketing, you’ve no doubt seen this boilerplate disclaimer: “Past performance is no guarantee of future results.” This is absolutely true. (And, with respect to mutual and exchange traded funds that tend to emphasize recent performance the language could be stronger, something like “the chances that a fund that has outperformed its peers in the recent past will outperform them in the near future are slim.” See the Chasing Performance section under the Exercising Common Sense tab.) Nevertheless, we all do look to the past for insight into the way things work in human affairs. In investing, where forecasting is very difficult, it is one of the best things we can go on. The key though is to look not just at the recent past, but what things look like over long stretches of time—think decades.
Long-term Returns of Different Types of Investments
Over long periods, certain types of investments, typically referred to as asset classes, have delivered significantly different returns. Below is a graph of four asset classes—3-Month US Treasury bills, 10-Year US Treasury bonds (both of which are obligations of the United States federal government), the S&P 500 Stock Index (an index of 500 of the largest publicly-traded stocks) and stocks of small capitalization companies (market capitalization or market value is a measure of size). I use these well-known asset classes because they have the longest history of returns data.
Over this period of 88 years, the compound average annual returns are: 3.5% for 3-Month T-Bills, 5.0% for 10-Year Treasuries, 9.5% for the S&P 500 and 11.2% for small capitalization stocks. In another excellent illustration of the power of compounding, the ending values of an initial $1,000 investment are dramatically different: about $19,800 for T-Bills, $70,600 for Treasuries, over $2.9 million for S&P 500 stocks and over $11.3 million for small cap stocks! So, over this long period of time, we can readily see stocks have had higher returns than bonds. Stocks of smaller companies have had higher returns than those of larger companies, and longer maturity (10-year) bonds have had higher returns than short maturity (3-month) bonds.
Price Volatility of Different Types of Investments
But we can also see there are significant stretches of time when this isn’t the case. For example, stocks did worse than bonds until about 1943, and T-Bills did better than Treasuries from the mid-1940s until about 1980. We can see this variability much more clearly when we look at the returns of these four asset classes for each year of this period.
We can make some clear observations. The returns of Treasury Bills didn’t change that much from year to year—the line looks pretty smooth. The returns on Treasury Bonds vary a bit more from year to year, especially from 1980 onward. Stock returns are much more variable from year to year than bonds, and the returns for small cap stocks are downright all over the place.
Interestingly, the asset classes with higher returns over the long term have tended to have returns that move around more over the short term. This is what people mean when they talk about return and risk being related. Higher returning assets tend to have more variability in returns, or volatility, which is one concept of risk I just discussed in the Understanding Risk section.
Now we can begin to appreciate how this concept of risk is important in practice. Say you’re saving for a down payment on a house that you hope to buy in a year, and you are figuring out how to invest those savings. Over time small cap stocks have provided the highest return, which is enticing. But there have been some years where they were down -25%, even -50%. If the next year leading up to your home purchase happens to be one of these years, it would be disastrous! These horribly negative years are infrequent, but they happen enough and the impact of the bad outcome is so great (no house) that this type of investment would be imprudent with so short a time frame.
Volatility in the Context of Time Frame: A Historical Analysis
Here we get to the crux of the matter. You need to think about expected returns and the likelihood of actually achieving those returns over the specific time frame you have to reach any financial goal. To help get insight into this truth, let’s look at average returns for different asset classes over ever-longer periods of time. And look at these blocks of time on a “rolling basis” to see how consistent those returns are. By rolling basis, I mean shifting a specified block of time, for example five years, forward by a year every year: for example, year-end 2000 to year-end 2005, YE2001 to YE2006, YE2002 to YE2007, etc.
To start, below let’s again look at annual returns for the period year-end 1927 to year-end 2015, but annual returns averaged over five-year blocks of time, moving through this period.
When we look at annual returns averaged over five year increments, they are not nearly as erratic as the year-to-year case we first examined (note the scale has been tightened from 150% to 50% maximum value), but they are still quite variable. Here’s a way to quantify this, specifically with regard to which asset class provides the highest return. We know that over this entire 88-year period, the compound average returns are: T-Bills 3.5% < T-Bonds 5.0% < S&P 500 9.5% < small cap stocks 11.2%. But, in 27% of these 5-year blocks of time, T-Bills actually returned more than T-Bonds. In 26% of these 5-year blocks, T Bonds returned more than stocks. And in 40% of these blocks, the S&P 500 returned more than small cap stocks.
Let’s look again at this same 88-year period, but now averaging annual returns in 10-year rolling blocks.
In 10-year increments, which asset class provided the highest return becomes more consistent again (note scale further reduced to maximum value of 35%). But still T-Bills returned more than T-Bonds in 34% of the 10-year blocks, T-Bonds returned more than stocks in 16% of the blocks and the S&P 500 returned more than small cap stocks in 37% of the blocks.
Finally, let’s look at average annualized returns in 20-year blocks of time, rolling through this same 88-year period.
In 20-year blocks of time, the return pattern for each asset class becomes much less erratic (note scale reduced further to maximum value of 25%), though variability certainly remains. The picture of which asset classes provide higher returns likewise becomes more clear. Over 20-year stretches, small cap stocks returned more than S&P 500 stocks most of the time, S&P 500 and small cap stocks returned more than 10-year Treasuries most of the time, and 10-Year Treasuries returned more than 3-month T-Bills most of the time. To quantify as we have, 10-Year Treasury bonds returned more than stocks in only 1% of the 20-year blocks of time. Though, T-Bills still returned more than 10-Year Treasuries in 30% of the 20-year blocks, and S&P 500 stocks still returned more than small cap stocks in 29% of the 20-year blocks.
What do we take away from this analysis?
First, based on historical returns, certain asset classes provide a higher return over long time periods, and given compounding effects, these higher returns result in dramatically more appreciation of your savings over time. Most importantly, stocks provide the highest returns.
Second, the longer the time frame you have to work with, the greater the likelihood of actually realizing these returns. Specifically:
- With an investment horizon of 20 years or more, which is often the case in retirement investing, you have a very high likelihood of generating the highest return with stocks—stocks outperformed government bonds in 99% of the 20-year stretches in our historical study—though no guarantee (there is that 1%, and the future may differ from the past). With 20 years, our study shows that small cap stocks returned more than S&P 500 stocks 71% of the time, and 10-year Treasury bonds more than Treasury bills 70% of the time. Still pretty good odds, but there are choices to be made based on your risk tolerance.
- With a time frame between 10 and 20 years, there is still a high probability that stocks will return more than bonds—this was the case in 84% of the 10-year periods we studied—though no guarantee (there is that 16%, and the future may differ from the past). With 10 years, our study showed that small cap stocks returned more than S&P 500 stocks 63% of the time, and 10-year Treasury bonds more than Treasury bills 66% of the time. For those with higher tolerance for risk, the potential for added return from assets like these may be attractive enough relative to taking on the increased potential for a worse outcome.
- With a time frame of 5 years, which asset class provides the best return becomes not much more than a coin toss, so an evenly-balanced mix makes the most sense.
- Less than five years is a very short horizon for investment. In this case, you should stick primarily to money market funds and short-maturity debt.
A key input in your financial planning must be the time frame for each of your goals. I show you an example of how you can link time frame to investment mix in the tabs on Goals-Based Asset Allocation and Model Portfolios.