12.4 Historical Picture of Returns to Stocks

U.S. equities have historically outperformed bonds and cash over long periods, with the S&P 500 averaging 10% annually from 1926 to 2021. However, short-term volatility can lead to significant fluctuations in annual returns, impacted by major events like recessions and geopolitical crises.

Different equity styles and sizes behave differently based on economic conditions. Growth stocks often outperform during expansions, while value stocks shine in downturns. Small-cap stocks typically offer higher returns but with greater volatility compared to large-caps, reflecting the cyclical nature of equity performance.

Historical Equity Market Performance

Equity market performance across periods

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• Long-term historical returns of U.S. equities consistently outperform bonds and cash investments over extended periods (decades)
  • From 1926 to 2021, the S&P 500 generated an average annual return of approximately 10%, showcasing the long-term growth potential of stocks
  • Reinvesting dividends contributes significantly to the total return of stocks over the long run (compound growth)
• Short-term volatility in equity returns leads to significant fluctuations in annual performance
  • Annual stock returns can deviate considerably from the long-term average due to market fluctuations and economic conditions
  • Volatility measures, such as standard deviation, quantify the degree of variation in stock returns over a given period
• Impact of major events on equity market performance can lead to periods of negative returns and increased uncertainty
  • Economic recessions (Great Depression 1929-1939, Global Financial Crisis 2007-2009) often coincide with significant market declines and increased volatility
  • Wars and geopolitical events (World War II, 9/11 terrorist attacks) can disrupt financial markets and lead to short-term sell-offs

Behavior of equity styles and sizes

• Performance of growth vs. value stocks varies depending on economic conditions and market sentiment
  • Growth stocks (technology companies) tend to outperform during periods of economic expansion and optimism
  • Value stocks (utilities, consumer staples) often perform better during economic downturns and recovery periods due to their more stable business models
• Returns of small-cap vs. large-cap stocks exhibit different risk and return characteristics
  • Small-cap stocks (Russell 2000 index) have historically generated higher returns than large-cap stocks (S&P 500) due to their higher growth potential
  • However, small-cap stocks are generally more volatile and sensitive to economic conditions, leading to larger price swings
• Cyclical nature of equity style performance leads to periods of outperformance and underperformance for different styles
  • Different equity styles and sizes may outperform or underperform depending on the stage of the economic cycle (expansion, peak, contraction, trough)
  • Investors can use style rotation strategies to adapt to changing market conditions by shifting allocations between growth, value, small-cap, and large-cap stocks

Market Dynamics and Performance Factors

• Market cycles influence equity performance over time
  • Bull markets are characterized by sustained periods of rising stock prices and investor optimism
  • Bear markets represent extended periods of declining stock prices and pessimistic investor sentiment
• Inflation-adjusted returns provide a more accurate picture of real investment growth by accounting for the effects of inflation on purchasing power
• Total return includes both capital appreciation and dividend income, offering a comprehensive measure of investment performance
• Market capitalization, which represents the total value of a company's outstanding shares, can impact stock performance and risk characteristics
• The efficient market hypothesis suggests that stock prices reflect all available information, making it difficult to consistently outperform the market

Interpretation of equity market data

• Reading and understanding stock market index charts helps identify trends and key price levels
  • Upward or downward movements in index values (S&P 500, Dow Jones Industrial Average) indicate broader market sentiment over different time periods
  • Support and resistance levels represent key price points where the market has historically found buying or selling pressure
• Analyzing historical return distributions provides insights into the range and frequency of returns
  • Histograms or frequency distributions visually represent the distribution of returns over a given period
  • Statistical measures, such as mean (average), median (middle value), and mode (most frequent value), help summarize the return distribution
• Comparing relative performance using line charts allows for the assessment of different equity segments
  • Plotting the performance of different equity styles, sizes, or sectors (technology, healthcare) relative to each other or a benchmark index (S&P 500) helps identify periods of outperformance or underperformance
  • Relative strength analysis compares the performance of one equity segment to another or the broader market to identify leadership trends