Global Stock Market Rollercoaster: Long-Term Returns and Short-Term Volatility Explained
The last two years have been a wild ride for the global stock market, with significant ups and downs. In 2022, the market experienced a steep decline of -18%, only to rebound and show a positive gain of +17% year to date in 2023. If you had been unaware of these fluctuations and had gone to sleep on December 31st, 2021, and woke up now, you might think that nothing particularly interesting had happened during those two years.
However, for those who experienced it in real-time, 2022 was a year of panic, while 2023 has been a year of euphoria. This is the nature of the stock market – a consistent short-term rollercoaster ride that tends to lead to higher returns in the long run.
At times like this, it’s essential to remind ourselves that the stock market is more like a long-term investment instrument rather than a platform for getting rich quickly. The stock market is where we allocate our savings, not where we make real investments. Our real investments are the skills we develop over time to earn income. It’s through these skills and income that we can truly build wealth.
Trying to use the stock market as a get-rich-quick scheme often leads to lower returns as it generates unnecessary taxes and fees. Instead, we should focus on building skills and products that generate income and then allocate our savings wisely.
When it comes to setting return goals, it’s crucial to be realistic. The global stock market has historically generated an average return of about 5.5% per year in inflation-adjusted terms. The bond market, on the other hand, has produced an average return of around 2.5% per year after adjusting for inflation. Cash investments, such as T-Bills, have generated approximately 0.5% per year after inflation.
While the stock market offers higher returns, it also comes with higher volatility. In fact, the stock market’s volatility is 2.5 times that of the bond market. So, to capture the stock market’s potential returns, one must be willing to endure significant downturns, with losses of over 20% and occasional drops of 40% or more.
Considering that the global financial markets are composed of roughly 50% stocks and 50% bonds, the average annual real return for the Global Financial Asset Portfolio is estimated to be around 4% per year before taxes and fees. Therefore, it’s important to have a realistic perspective on the actual returns we can expect from the financial markets.
When designing a financial plan, it is crucial to consider time-based allocation. Our lives are not solely defined by long-term or short-term goals. We have daily, monthly, annual, and decade-long commitments and expenses. A well-thought-out financial plan should allocate assets based on different time horizons, ensuring we have the necessary funds to meet our various financial goals.
By employing a time-blocking asset allocation strategy, we can better understand and plan for our goals by identifying how specific assets help us meet different time-based financial objectives. This approach not only provides clarity but also instills confidence in our asset allocation decisions.
During market booms and busts, it’s crucial not to succumb to the temptation of chasing panic or euphoria. The worst mistake an investor can make is altering their target returns based on short-term market movements. Changing risk profiles during booms often leads to increased risk exposure rather than higher returns. This not only disrupts the balance of your asset allocation but also increases the likelihood of overreacting when the stock market eventually experiences a downturn. Instead, it’s better to establish realistic goals and stick to them, irrespective of short-term market fluctuations.
By reminding ourselves of these key facts and adhering to these guidelines, we can navigate the short-term market booms more effectively. Remember, building wealth comes from developing skills and earning income, while allocating our savings prudently ensures long-term financial stability.
