Markets haven’t read the manual

Over the past 100 years, there have been more years in which stock markets gained 20% or more than those in which equity markets posted a loss.

Consistency matters more than we think. Even an investor unlucky enough to invest in the worst-performing asset class (across equities, sovereign bonds and corporate bonds) at the worst possible time every year would still have generated a positive return over time by investing consistently since the end of World War II.

If, over the past 40 years, you had invested only EUR 1 at each US stock market high (as measured by the S&P 500 index), your internal rate of return (IRR) would be 10% today. And if you had invested only at market lows, your IRR over that same time period would be of 11%.

The volatility of annualised returns diminishes with time. For instance, the volatility of returns on eurozone equities is 20% over a 1-year horizon, but the volatility of annualised returns on that same market falls to 9% over a 5-year period, and to 4% over a 10-year period. The longer the investment horizon, the closer the annualised return gets to its historical average. However, drawdowns and structural shifts remain hard to predict.

Many people believe that holding an investment for the long term will always generate good returns, but this view overlooks an important fact: since 1928, US stocks have spent one out of every four years in periods of low to negative returns, including so called “lost decades” – periods of structural decline characterised by stagnation and low to negative real returns. The same holds true for bonds (e.g. from 1940 to 1981, and more recently since 2021).

What’s the biggest risk for an investor? In fact, it’s not so much volatility as the possibility of an exceptional loss. Investors are rewarded not only for riding out daily market fluctuations but also, and more importantly, for bearing the risk that a crash could be right around the corner. US real GDP fell by around 30% during the Great Depression and US stocks plunged by nearly 65%. But the most devastating outcome was actually a more insidious one – the US dollar has lost close to 97% of its purchasing power since 1913.

The average yearly drawdown in equity markets is around -12%. In fact, historical data shows that in one out of every three years, markets experienced an intra-year correction of -12% or more – yet 30% of those years still ended with a positive full-year return, averaging around +19%.

Bonds, unlike equities, tend to have a clearer anchor: the yield to maturity (YTM). The YTM at a given time tends to be a decent proxy for future returns (assuming an appropriate investment horizon). Close to 82% of returns on high-yield bonds five years out can be attributed to the YTM. This figure rises to 90% for investment-grade bonds.

“Star” global equity funds tend to have one thing in common: they rank in the top quartile based on their long-term returns. But that tends to mask significant discrepancies over shorter time periods. If we take a sample of six largely favoured funds that are all in the top quartile based on their 10-year returns, only 50% remain in the top quartile if we consider their 5-year or 3-year returns. Even champions can have a losing season.

If you had invested €100,000 30 years ago in a global equity fund that delivered a 6% average annual return (which broadly corresponds to the performance of global equity markets over that period), such an investment would be worth €574,000 today. But if that portfolio gained an additional 0.5% per year (which corresponds to the average outperformance achieved by genuinely active global equity funds) you would have ended up with an extra €90,000. And if that annual outperformance had been 4% (which is what Carmignac Investissement¹ achieved over the period) you would have ended up with a total of €1,744,940 today – an extra gain of over €1 million.