Will the Stock Market Ever Return to “The Good Old Days?”

MintLife investing expert Matthew Amster-Burton is answering questions from Mint.com Facebook fans.

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MintLife reader Ryan asks:

Why bother anymore? The stock market, even mutual funds, struggle for a constant 3-4%, nothing like the 6-10% like it used to be.

and reader Wesley asks:

I have a little bit of money in a Roth IRA that I started last year. The return has been something like 20% this past year.

I know stock market returns vary year to year, but with the way things are going, should I be maximizing my Roth contributions and just paying the minimums on my 6% student loan and 3% car loan?

I feel like if I divert my extra cash to those loans instead of the stock market I’ll be losing out on some great returns these next few years.

Boys, get it together! Is it 20% or barely 3 to 4%?

I’m glad you asked, because most of us have no idea.

One of my all-time favorite studies in the world of personal finance followed over 3000 individual investors in Germany from 1997 to 2001.

The academics tracked investors’ actual returns and then asked them a simple question: “What was your annual rate of return?”

The result: “Investors are hardly able to give a correct estimate of their own past realized stock portfolio performance over the past four years. The correlation coefficient between return estimates and realized returns is not distinguishable from zero.”

In other words, investors had absolutely no flipping idea whether they made 3%, 20%, or something else. Most overestimated their returns.

In fact, investors weren’t even good at estimating whether they’d made or lost money.

As I said, this study was done over ten years ago in Germany. But the investors were using an online brokerage, and there’s no reason to think the results wouldn’t be replicable right here, right now.

The authors of the study attribute the investors’ terrible guesses to two factors: investors are generally overconfident, and online brokerages do a lousy job of showing us our total return.

The facts

I don’t have the power to look into Ryan and Wesley’s brokerage accounts, and I was too polite to ask.

But if we assume both investors hold portfolios tilted toward stocks, Wesley is more right than Ryan when it comes to this year’s returns.

The S&P 500 (including dividends) is up 29% this year, as of November 22. Bonds have had a lousy year: Vanguard’s Total Bond Market Index (a good stand-in for the total US bond market) is down 1.67%.

If Wesley’s Roth IRA holds 70% stocks and 30% bonds, a 20% return this year is about right. Or, alternatively, if he’s holding a portfolio of 100% stocks in a total world stock index, that’s up about 20% this year, too.

So let’s take Wesley’s question first. I don’t doubt that Wesley’s made some great money this year in his Roth IRA.

Whenever you have a good year in the markets, it’s natural to assume that the good times will last forever, or at least a while.

But there’s no reason to assume that. Have you ever looked at Callan’s Periodic Table of Investment Returns?

It’s a simple but information-packed chart ranking asset classes (US stocks, international stocks, bonds, emerging markets, and so on) from best to worst, every year from 1993 to the present.

Basically, it’s unusual for the best-performing investment of one year to be the best next year, and it’s common for the worst stinker of this year to be on top next year.

In fact, that happened most recently last year, when emerging markets went from worst of 2011 to best of 2012.

Now, is it possible that Wesley’s portfolio will return 20% again next year? Sure, it’s possible. But is it likely enough that it’s worth borrowing at 6% to invest more?

Because that’s what Wesley is doing if he chooses to invest more rather than paying down his loans.

The question for you, Wesley, is: if I offered to loan you money at 6% interest, would you borrow from me in order to invest more money in stocks?

If not, you’re better off paying down the loan.

The good old days?

Now, back to Ryan’s question. The stock market sure seems to be all over the place lately, doesn’t it?

The S&P 500 was down 37% in 2008, up 26.5% in 2009. Up a lousy 2% in 2011, then up 16% in 2012.

What happened to the good old days when the stock market returned a steady 6% to 10%? Easy: they never existed.

Volatility and long-term bear markets are a standard part of stock investing.

One of the worst bear markets in US history lasted from 1968 to 1982, when stocks went basically nowhere for 14 years and people talked about the “death of equities.”

At the same time, bull markets and a long-term upward trend are also a standard part of stock markets.

The answer to “why bother?” is that stocks have been a pretty good bet more often than not: people who invest in stocks, stay invested in good times and bad, rebalance, and keep management costs low, usually make considerably more money than those who keep all their money in bonds or other safer investments.

And that “usually” is exactly why people tend to make more money in stocks. They’re being compensated for taking risks.

If stocks had a long history of volatility and bear markets and offered a historic return of 2%, few people would ever invest in stocks.

So forget about the good old days.

If you want stock market returns, you have to expect stock market behavior: the market will throw fits, go into long-term funks, and explode into manias and bubbles.

Why bother?

Because most people want more from their investments than the modest returns offered by bonds and CDs, and a diversified stock index fund is the best risky investment out there.

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.