2018 was an odd year for asset class returns. Every asset class yielded negative real returns. Only a few asset classes yielded positive nominal returns, but failed to keep pace with inflation.
Cash and short-term bonds performed the best, yielding between 0-2%, presumably because the return of market volatility scared investors into cash positions. Inflation increased by 1.91% for the year as global economies continued to remain fairly strong, so purchasing power eroded.
What can we learn from this?
Markets are unpredictable.
Sometimes market history will repeat itself… until it doesn’t. Past performance is not an indicator of future performance.
To me this is a great reminder of market risk. Investors are rewarded with returns for taking that risk, but the risk still exists and sometimes it materializes into losses. 2018 was not a terrible year for US stocks, which lost 5% in value, when compared to years in which there were major corrections such as 2002 and 2008.
But 2018 was a very challenging year for international markets, where both developed markets and emerging markets were down 14%. Some stock markets had major declines in 2018, such as China’s whose Shanghai and Shenzhen markets were both down more than 24% for the year.
The expected return is rarely the actual market return
Investors widely claim, as well as expect, that the stock market will return about 10% annually. This figure is based on historical returns of markets and indices (and should be noted is a nominal return value).
However, the market rarely returns around 10% in a year. In some years markets return much more, and in some years less, even much less. But over long periods of time the markets have on average returned around 10%.
In the graphic below you can see that it was more likely that the market returned 15-25% than 5-15%. And it was much more likely that the market returned something outside of 5-15%, than something within the 5-15% range.
To me, this is a good reminder that it’s hard to know when to be invested or not invested in the markets, so we should not try to time the market. By attempting to time the markets, there’s a strong possibility you may miss out on some of the best periods of growth in the markets. Without being invested, through both the good years and bad years, you cannot achieve the expected market return of 10%.
So what should we do as investors?
As investors we aim to maximize our returns for our own acceptable level of risk that we’re willing to take with our investments. Everyone will have a different level of personal risk tolerance, but we all have to manage the risks of unpredictable markets and volatile asset class returns.
Investors should take two things away from this:
- Invest for the long-term
- Use diversification
By investing for the long-term, you can avoid the risk of the short-term year-to-year fluctuations of the market and achieve the expected gains (which are long-term averages). By using diversification you can reduce the risk of specific asset class volatility, increasing the probability of achieving the expected long-term returns. Together, these two principles create a robust investment strategy for building wealth and minimizing risk.