Dear Friends,

One of my family’s traditions is our beginning-of-summer trip to visit my wife’s family in western Wisconsin.  We’ve made this trip on Memorial Day weekend for each of the 16 years since we relocated to Phoenix.  Every year as our travel date nears we look at the historical temperatures for Minneapolis in late May, and every year, we see its average high temperature of 72 degrees.   To Phoenicians accustomed to 100+ degrees on Memorial Day, it brings visions of paradise.  Warm enough to do things outside with our son during the day, but cool enough to wear a light jacket or sweater in the evenings.  Inevitably, we begin planning our activities around those idyllic low 70s temperatures.

Unfortunately, once we arrive in the Midwest we usually get an unfriendly reminder of reality.  While the long-term average high is 72 degrees, the actual high temperature we experience each year is usually dramatically different than the average temperature we had conditioned ourselves to while packing.

As the graphic above illustrates, some years the weather’s been near 90 degrees and humid, other years the nighttime lows have been barely above freezing.   Not surprisingly, during the first few years we made this trip, we were repeatedly frustrated by the impact the “unexpected” weather would have on our plans and the resulting uselessness of much of the wardrobe we (or more accurately, my wife) had packed with such anticipation.

Like planning for a Memorial Day trip to the Midwest, expecting the average can also be frustrating and even dangerous in the world of investing.  Just like temperatures, we can calculate the long-term average returns of the stock market over long time periods.  In the case of U.S. stocks, the average 12-month return has been about 12%.   But the actual return in any single year has rarely been close to 12%.

The graphic above shows the percentage of years where the return of US stocks has fallen into each return “bucket”.  As you can see, history tells us that in any one single year, stocks are far more likely to produce an “extreme” return (a gain of greater than 25%, or a loss) than they are to generate a return near the long-term average of 12%.  As a result, successful investors (just like seasoned Midwestern travelers) must learn to “expect the unexpected” in the short-term.

If we change our investment mindset from the short-term to the long-term, something very interesting happens.  Because long-term stock returns have tended to “revert to the mean” (alternate unpredictably between above-average and below-average) the long-term annualized returns of stocks tend to cluster between 10-15%.  Thus, while reviewing the long-term average is of little use in packing for a trip to the Midwest or predicting next year’s stock market, it is very useful for long-term financial planning.

It’s important to recognize that long-term annualized returns of 10-15% cannot be achieved without being prepared to stomach a roller coaster of emotions associated with losses in one year and gains of 25% returns the next.  But if you have a long time before you need to spend the money you’re investing, take a note from my family’s Midwestern travel experiences:  Pack both your t-shirts and your winter coat, and resist the temptation to make any plans that are dependent on your ability to predict what the short-term will be like.  Maintaining flexibility, both in your spending goals and your emotions, will give you the best chance to capture the attractive long-term returns that the stock market has historically provided.

Sincerely,

Chuck Carroll, CFA, CAIA

Chief Investment Officer

TFO Phoenix, Inc.

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