By PATRICK CAIRNS
Over the last 30 years, the FTSE All Share Index has delivered an average annual return of 9.3%. In a world where 10 year government bonds are yielding less than 1%, that seems like a great number to be sharing with your clients.
Certainly in one respect it is. Decades of research clearly show that the best way to grow your wealth over meaningful periods of time is through investing in the stock market.
The work done by London Business School professors Elroy Dimson, Paul Marsh and Mike Staunton for their book Triumph of the Optimists showed that in all of the countries that they studied around the world, stocks out-performed bonds over the long term. And as Dimson notes, there is every reason to expect this to continue to be the case:
“(The outperformance of equities) is not simply a pattern from the past; it reflects the theory that risky securities should command a lower price than otherwise similar safe securities. Risky equities can therefore be expected to offer a higher expected return.”
This is why it makes sense for financial advisers to encourage their clients with long enough time horizons to have adequate exposure to the stock market. Telling them that the FTSE All Share Index has returned 9.3% on average every year since 1990 appears like a good way of doing that.
Setting the expectation
In another respect, however, telling a client that the market has produced this return is only setting yourself up to have to explain yourself later. Because in the 30 years since 1990, the FTSE All Share Index has never once produced an annual return of 9.3%.
In fact, it has not been within 30% of that number. The closest it came was the 12.3% gain achieved in 2012.
The reason this is important is because of the behavioural concept of 'anchoring'. Effectively, by telling a client that the market has averaged a return of 9.3% per year, that is where you are setting their expectation. They will see that as standard and their response to how the market performs will be based off that.
This becomes extremely problematic if you encounter a year like 2008, when the market fell by 29.9%. It is easier, but still tricky, when the market performs as it did between 1991 and 1993, when it recorded gains of 20.8%, 20.5% and 28.4%.
These are extremes, but in both cases those returns look nothing like 9.3% per year. If that was the only figure you discussed, your client would understandably be questioning your credibility.
Painting a picture
Averages in general have the potential to be misleading, but this is particularly the case for something as volatile as the stock market. They may sound encouraging, but using them invites the potential for poor investor behaviour because they are rarely, if ever, actually realised, particularly in the short term. Investors may therefore over-react when the expectation that has been set for them is not met.
This may lead to over-exuberance when the market materially out-performs the average, as it did in the early 1990s, which then leads to the challenge of managing expectations downwards. Or it may lead to rapid capitulation in a period of under-performance, which may be the end of your relationship with the client.
This is why behavioural finance experts recommend presenting returns in their range over longer time periods. This has the benefit of providing a much wider base from which clients anchor their expectations, rather than a single point.
It is also important that this is done over periods of five years and longer, because one year performance can be so volatile. Clients can then be encouraged to persevere with their investments when they can see that what they are experiencing is within a normal range, even if it isn't meeting the average.
The table below shows the range in which FTSE All Share Index returns have fallen over three different rolling time frames for the past 30 years. These are calculated from annual, calendar year numbers.
These may appear less eye-catching than the 9.3% average mentioned earlier, but they present a far more rounded picture. Placing these before a client would anchor their expectations not on a single figure, but on a more balanced idea of what the market can deliver.
This not only reduces the likelihood of either unreasonable disappointment or unfounded eagerness when the market fails to perform to its 'average', but also allows for a more honest discussion about what their goals are, and the realistic chances of meeting them.
Importantly, these figures all require someone to be invested for at least five years before the return they have earned can be compared. This encourages clients to stay invested, and take short term market movements out of their thinking.
Photo by Grant Durr on Unsplash