Reasonable return on stocks held long-term
The importance of long-term estimates of returns
It can be difficult timing returns to markets on a yearly basis but research shows that over extended periods of time, even asset classes considered risky such as equities can be positive in terms of risk factors for the investor who is discerning and patient. A sound long-term investment plan acts as a road map to help investors to set long-term objectives but, in order to achieve these objectives, it is imperative for the investor to require reasonable estimates of what long-term returns on equities could look like.
For instance, over optimistic estimates will almost certainly result in not achieving your objectives such as security after you retire or the ability to pay for the education of your children. On the other hand, estimates that are unduly pessimistic, you may be needlessly sacrificing some of your current comforts and cutting down on your current lifestyle in order to generate the resources for your long-term investment plans. In other words, you are unlikely to achieve your realistic objectives however achievable by using unrealistic assumptions while developing your plan.
There are lots of arguments that the focus should be on short-term asset allocation and short-term returns because of the difficulty in drawing up realistic and accurate long-term estimates. The truth of the matter is that because short-term estimates are far more volatile, you have a much better chance of being wrong. Most investors have at least one long-term objective and possibly more including retirement savings and education for the children and they will therefore have to plan how much they should be saving now in order to realise these long-term plans.
The truth is that you always have to bear in mind that when it comes to looking at returns and forecasts, the term long-term is not specifically define though there is a well accepted thumb rule that the period should be more than 10 years. It is sensible to strike a balance between shorter term market forecasts and really long periods of time when you are less confident about predicting the future. A sensible compromise could be a 20 year time horizon though, given the nature of your exercise, there should be no significant variation in your results whether you are using the period of 10 years or 30 years.
A consensus for the forecasts for expected returns for 2015 are 6.3% compounded annually for the S and P 500, 7.1% compounded annually for mid-and small cap stocks such as the Russell 2006 and 6.1% compounded annually for international stocks such as MSCI and EAFE. These estimates are below historical averages because the estimate of long-run inflation is just under 2% annually compared to the historical average between 1970 and 2014 of 4.2% and because current and forecast interest rates are significantly lower than the high interest rate environment of the 1980s.
What you should be doing
The question now arises as to what you can do in environments like the current one of low returns. This is important because the power of compounding can have a profound effect on your ability to meet your long-term investment objectives. If you are faced with returns lower than you had expected, you should try and do something about it instead of hoping that the problem will just go away if you do nothing at all. It is always better to adjust to a more realistic scenario. For instance, try and keep fees and taxes to an absolute minimum to maximise your return. If you don't have a long-term investment plan, this is probably a good time to try and put one together.
Understanding what makes up average returns
There are several factors that make up the composition of average returns. The return on large cap stocks works out to around 10% compounded monthly over the period 1926 to 2014. This return can be broken down into three major components namely inflation (referred to as A), returns from capital appreciation adjusted for inflation (B) and returns from dividends (C). Next the inflation-adjusted capital appreciation B needs to be further broken down into the historic P/E ratio (D) and the growth in EPS adjusted for inflation (E). The historical average return can be now calculated as the sum of A +C +D +E.
Examples of stocks meeting our return criteria
An excellent example of stocks meeting our criteria are the big four Australian banks which have delivered to their shareholders for more than 10 years. These banks are also among the most profitable banks in the developed world. Commonwealth Bank has locations in a number of countries including Australia, New Zealand, Asia, the UK and the US and a wide range of services. National Australia Bank is ranked the highest of the big four and the 17th largest in the world by market capitalisation serving more than 8 million customers. Westpac has 1200 branches and 2980 ATMs serving around 13 million customers.The Australia and New Zealand Banking Group is the third largest of the big four Australian banks by market capitalisation and retail and commercial banking as its backbone. REA Group Limited has a dominant market leadership position in the Australian online residential property market and has a five-year EPS growth rate has been 34.72% compared to 30.63% for the industry and 22.03% for the sector and a five-year average for return on equity of 40.66% compared to 14.94% and 23.22% respectively.SEEK Limited again has clear leadership in the job placements market with 22% of Australian placements and an unprompted awareness of 76%.
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