I’m a big fan of safety margins. When I drive over a bridge, I’m glad it has been designed for several times the weight of the cars on it. Investing strategies should be designed so that you’ll be okay financially even if your returns are lower than you hope. But, we can sometimes make the mistake of layering too many safety margins and lose track of likely outcomes.
In his Book, The Intelligent Portfolio, Christopher L. Jones does some computer simulations to show that even though the S&P 500 returned an average compound rate of 6% above inflation for the past 40 years, there was a 1 out of 20 chance that the return could have been as low as 1.2% above inflation.
This analysis is based on a strong version of the efficient market hypothesis that includes assumptions about the distributions of stock market returns. What happens if we take a look at actual returns over the past century?
According to this chart produced by Crestmont Research, in the 58 rolling 40-year periods since 1910, the S&P 500 compound average return has ranged from inflation plus 3% to inflation plus 8%. This is the average compound rate taking into account transaction costs such as bid-ask spreads, commissions, and other fees (but not taxes).
So, even taking into account transaction costs, there has never been a 40-year period in the past century with returns as low as inflation plus 1.2%. Either we have been lucky, or Jones’ model is wrong.
It’s amazing what many people choose to worry about: very poor stock market returns for more than a generation, terrorist attacks, and meteors. If you want something real to worry about, then think about cancer and heart disease. I’m much more likely to die in the next 40 years than I am to see stocks lose out to inflation.