Let’s say that we use the Vanguard Total Stock Market Index Fund Investor Shares to measure the performance of the total U.S. stock market. In that case, if we combine all of the fund’s annual returns, then the total U.S. stock market has grown at an average rate of 10.54% each year.
Now, risk can be thought of as the amount of variation around this average rate of return, and the statistical term that is used to describe this variation is known as standard deviation. So, with that said, if we take all of the fund’s annual returns and plug them into the appropriate formula, the standard deviation of the total U.S. stock market is 17.23%.
Alright. With these two numbers, we can now start to get a sense of the risk that’s involved in investing in the total U.S. stock market.
So, first of all, you can expect that 68% of the time, the annual return of the total U.S. stock market will fall within one standard deviation. In other words, if you have an investment time horizon of 50 years, then you can expect that in 34 of those years, the rate of return for the total U.S. stock market will be between -6.69% (10.54% – 17.23%) and 27.77% (10.54% + 17.23%) each year.
At the same time, though, those aren’t the only results you can expect. You see, in addition to this, annual returns can also fall outside of one standard deviation, but within two standard deviations.
And in this case, returns will stay within two standard deviations 95% of the time. So, to put it another way, with the same investment timeframe of 50 years, you can expect that in about 47 of those years, the rate of return for the total U.S. stock market will be between -23.92% (10.54% – 2×17.23%) and 45% (10.54% + 2×17.23%) each year.
And on top of that, returns can even be outside of two standard deviations, but within three standard deviations. Here, results will fall within three standard deviations 99.7% of the time. So once again, if you have an investment time horizon of 50 years, you can expect that in about 49 of those 50 years, the rate of return for the total U.S. stock market will be within -41.15% (10.54% – 3×17.23%) and 62.23% (10.54% + 3×17.23%) each year.
Alright. Now, what we’ve just gone over with these three scenarios is simply one way to describe risk. But, there’s another way to get a sense of the risk and reward that comes with investing in the total U.S. stock market which you may find more helpful.
You see, the year-by-year returns that are combined to give us the average rate of return of 10.54% each year don’t paint the complete picture for us. To be more specific, let’s take a look at how the pattern of returns changes as you make progress from staying invested in the total U.S. stock market for only one year at a time, to five years at a time, and all the way up to 30 years at a time.
To begin with, once again, as this table of annual returns shows, the one-year-at-a-time results are all over the map. There are both large and small gains as well as large and small losses, and they all occur in what looks like a random pattern. For instance, the table below summarizes the results.
1-Year Periods
| Average annual return | 10.54% |
| Best year | 35.79% |
| Worst year | -37.04% |
| Years with gains | 26 (79%) |
| Years with losses | 7 (21%) |
As you can see, if you held onto the total U.S. stock market for one year at a time, then at best, you earned 35 percent in a year, and at worst you also lost 37 percent. And because of this, it doesn’t seem very helpful to summarize these wildly different one-year results into a neat and tidy “average” rate of return of 10 percent, does it?
But, if you begin to extend the time horizon and look at the returns achieved by holding on to your investment for five years at a time, then the numbers start to make a bit more sense. Check out the table below.
5-Year Periods
| Average annual return | 10.01% |
| Best 5-year period | 26.84% |
| Worst 5-year period | -1.76% |
| 5-year periods with gains | 26 (90%) |
| 5-year periods with losses | 3 (10%) |
Here, we see that there are fewer periods with losses, and the periods where you make money appear more often compared to the periods with losses.
“Why did this happen?” you ask. Well, the reason is because as you increase the measurement period, the average annual rate of return begins to overpower the single-year differences.
So, what we begin to uncover from these first two examples is that the length of time that you stay invested in the total U.S. stock market is an extremely important factor that determines both if and how much money you make. In fact, the remaining examples will reinforce this idea.
Now, if we continue to extend the time horizon and move on to holding on to your investment for 10 years at a time, then once again, the numbers are a bit more dependable.
10-Year Periods
| Average annual return | 8.79% |
| Best 10-year period | 16.16% |
| Worst 10-year period | -0.66% |
| 10-year periods with gains | 22 (92%) |
| 10-year periods with losses | 2 (8%) |
Here, there are fewer periods where you lose money, and the periods with gains appear more often compared to the periods with losses.
Next, as we shift over to holding on the total U.S. stock market for 15 years at a time, there’s even more consistency in the results you experience.
15-Year Periods
| Average annual return | 8.49% |
| Best 15-year period | 13.73% |
| Worst 15-year period | 4.75% |
| 15-year periods with gains | 19 (100%) |
| 15-year periods with losses | 0 (0%) |
As you can see, there are no periods where you lost money. So, the sting of losing money is finally removed after 15 years. Or, to put it another way, in every period you made money, and what’s even more exciting is that the range of returns begin to stick much closer to the average annual rate of return.
And to highlight this phenomenon even further, the tables below summarize the results you would’ve achieved by holding on to the total U.S. stock market from between 20 years at a time through 30 years at a time.
20-Year Periods
| Average annual return | 8.65% |
| Best 20-year period | 10.70% |
| Worst 20-year period | 6.01% |
| 20-year periods with gains | 14 (100%) |
| 20-year periods with losses | 0 (0%) |
25-Year Periods
| Average annual return | 8.89% |
| Best 25-year period | 10.12% |
| Worst 25-year period | 7.65% |
| 25-year periods with gains | 9 (100%) |
| 25-year periods with losses | 0 (0%) |
30-Year Periods
| Average annual return | 10.06% |
| Best 30-year period | 10.71% |
| Worst 30-year period | 9.45% |
| 30-year periods with gains | 4 (100%) |
| 30-year periods with losses | 0 (0%) |
Now, as you look at the best and worst periods in each table, even though there are some pretty big differences in the range of returns realized in each of the seven different time periods, the average annual return is pretty consistent in all cases–between more than 8 percent to under 11 percent. And the reason for this is because the returns are all calculated from the same original set of numbers.
Again, what we learn from these examples is that if your time horizon is short, the total U.S. stock market may not look very desirable, and you might want to avoid it. But if your time period is long enough, you can invest in the total U.S. stock market that seems risky in the short run, and you can do so without the fear of losing your money.
To put it another way, the longer you hold on to the total U.S. stock market, the less risky it becomes. You see, even with the stock market crash that took place from 2000 to 2002, and another crash that we experienced in 2008, as a long-term investor, you never lost money if you simply stayed invested in the total U.S. stock market for 15 years or more.
Now, you may be wondering, “Is it really reasonable to expect me to wait 15 years or more before making money in the stock market?”
Well, if that’s what you’re thinking, then it might not be a good idea to underestimate your investing time horizon. For instance, if you start making regular deposits to a retirement plan at age 25, and then, in retirement, begin to draw on the money you’ve accumulated until age 70 and beyond, you’d have an investment lifetime of 45 years or even more.
Once again, as long as you’re committed to holding on to your investment for a very long time, you’ve automatically insured yourself against the pain of short-term price swings. In other words, if you can earn substantial long-term returns, then in the grand scheme of things, does it really matter if you’ve lost and regained about 40 percent of your investments along the way?
And, since inflation has been a significant part of our history, isn’t the real risk that you face in the long run the risk of seeing the purchasing power of your money erode as a result of being too cautious?
So, the bottom line is that the solution to the problem of short-term risk is to become a long-term investor. That way, you can simply ignore the temporary instability in stock prices, and instead put yourself on the tried-and-true path to becoming wealthy–all while sleeping better at night.
Leave a Reply