Lower Prices Mean Higher Expected Returns

Investing is the only area of our lives where we celebrate higher prices and bemoan lower ones.  Think about it, whether you’re shopping for groceries or a new car, the lower the price for the things you want, the more you are apt to buy them.  But not so with investing.  

When our investment statements show we have more money than we did last month, last quarter, or last year, we generally feel better and even consider adding more money to our portfolios.  When values are down, as they are this year, we think less of our investments, and some people even consider selling them—at lower prices!?!—thinking we’ll get back in when things get better (and prices are higher).

Buy high/sell low investing behavior costs us a lot over time; I’ve called it the biggest cost of investing.  The average investor in the last decade has earned a 1.7% per year lower return on their mutual funds than the funds made because they bought and sold at the wrong time.  And it isn’t just the “average” investor that pays this behavioral cost.  In The Bogle Effect, Eric Balchunas tells a story (p. 136) of cost-sensitive Vanguard investors in their Growth and Value Index Funds who from 1992 inception through 2019 earned 4.5% per year in each fund, even though both funds had returns of 9% per year!  They gave up half their potential return by going to Growth after a good run and then hopping on the Value Fund after it outperformed, only to see the cycles reverse soon after making the change.

This behavior seems crazy to me.  We should treat lower prices on our investments like everything else: an opportunity or at least a reason for optimism.  Why? Higher prices generally lead to lower future returns, but the opposite is true of lower prices—they lead to higher future expected returns.  Simply put, the less you pay, the more you’ll get.  Right?

Of course, we’re not just going to rely on old axioms; we need to work this out with evidence.

Let’s use the Dimensional Core Plus 100/0 Wealth Index as our investment example—a globally diversified stock portfolio of several Dimensional Indexes that overweights the known drivers of expected return: small companies, lower-priced value companies, and higher profitability companies.  Dimensional provides data on this index starting in 1985.

Over the entire period from January 1985 through July 2022, the Dimensional Core Plus 100/0 Wealth Index averaged +11.2% per year and +9.9% over all rolling 10-year periods.  Keep these returns in mind.  The index also had 11 different periods where it declined by at least -10%; the average of all these declines was -22.7%.  The long-term cumulative returns, as well as the numerous temporary setbacks, can be seen in the chart below.

I am first concerned with the long-term, 10-year return on this index during the periods that started with the -10% or greater decline.  For example, the index lost -23.6% from September through November 1987, so I calculated its 10-year return from September 1987 through August 1997 (+10.1% per year).  

In the seven periods where we have another decade of returns to observe (declines in 2016, 2018, 2020, and this year can’t help us yet), I find the average 10-year return with a bad start (-10% or more decline) was +8.6% per year.  Not surprisingly, 8.6% per year is a little lower than the +9.9% over all 10-year periods.

Next, to determine if a decline, and the resulting lower prices, tend to lead to higher or lower future returns, I looked at the remainder of these 10-year periods AFTER the decline had ended.  In the example above, I then looked at the returns from December 1987 through August 1997 (which was +13.5%/yr).  

In every single case, the return on the index for the remainder of the period (following the decline) was much higher than the index’s return over the entire 10-year period.  The average return over all of the remaining periods was +13.1% per year, 4.5%/yr higher than the average during the whole period, and over 3% per year higher than the average over all 10-year periods.  Lower prices clearly equal higher expected returns.

What about maintaining the 10-year window and looking out an entire decade after the decline?  Continuing our example, what about December 1987 through November 1997 (+13.2% in this case)?  Overall, were future decade-long returns higher or lower than before the declines?  Again higher.  

For the full 10-year periods after the -10%+ declines end, the average return on the Dimensional Core Plus 100/0 Wealth Index was +12.5% per year, much higher than the +8.6%/yr average decade return starting with the decline.  12.5% isn’t as high as the +13.1% for the remainder of the initial 10 years, but that’s because we’re adding more months, and in some cases years, to our observation.  The farther away we get from the initial recovery—which is always where returns are highest—the lower the returns tend to get.  But the fact remains—after a decline, and in the midst of lower prices, future expected returns are much higher.

I realize that looking at returns after each of these declines ended has an issue with hindsight bias—we didn’t know how far the index would fall at the time.  Were future expected returns higher in the middle of these declines too, when (unbeknownst to us) the declines still had further to go?  Or did we have to wait until the decline had ended to see higher future returns?  

To answer this, let’s look at two specific examples: 2000-2002 and 2007-2009.

From September 2000 through September 2002, the Dimensional Core Plus 100/0 Wealth Index dropped by 26.8%, its second worst decline of the whole period. But most of the decline happened in the first year, between September 2000 and September 2001, where the index fell by 18.7%.  While the return over the entire 10-year period starting with this decline (September 2000 through August 2010) was among the lowest of all 10-year periods, just +4.7% per year, the return for the remainder of these ten years AFTER the -18.7% decline in the first year was higher—+7.7% per year (from October 2001 through August 2010).  As the index continued to decline, bottoming out in September of the following year, the remaining return got higher—+10.2% per year from October 2002 through August 2010.  

So we see that lower prices don’t always mean they can’t get a little lower still; the lower they go, the higher the future expected returns will be.  In other words, the more significant the decline, the bigger you should expect the recovery to be.

What about the 2007-2009 period?  

Despite a total decline of -54%—the worst loss for a diversified stock portfolio since The Great Depression—we didn’t see the cumulative loss eclipse -20% until after the September 2008 plunge triggered by the bankruptcy of Lehman Brothers.  From November 2007 through September 2008, the Dimensional Core Plus 100/0 Wealth Index had fallen by 26.9%, but unbeknownst to many, it still was only 1/2 way to its eventual bottom.

The 10-year period from November 2007 through October 2017 was predictably low, just +6.3% per year.  What was the annualized return starting instead in October 2008 through October 2017, after the first stage of the decline?  It was much higher, +10.7% per year.  Of course, the index declined violently for another five months before bottoming out, and expected returns at that point, in March 2009, were higher still: +17.3% per year annually through October 2017.

Once again, it’s what we expect—the lower stock prices go, the higher future expected returns should be.  The bigger the declines, the bigger the expected recovery.

What does this mean for investors? Even a well designed portfolio that is perfectly appropriate for your goals will sometimes go down.  This is not a reason to doubt the portfolio or to become pessimistic about it, and it certainly isn’t a reason to stop contributing to it or sell out of it.  Lower stock and portfolio prices reflect new (worse) information and expectations about the economy’s future, interest rates, corporate earnings, and other variables that impact equity values.  And as we’ve seen, when prices are temporarily lower, future returns tend to be much higher and higher than average.  

Even if you’re not following the statistics, doesn’t it make sense to expect a higher return when conditions are relatively more pessimistic and a lower return when conditions are more optimistic?  The higher-expected returns have a way of drawing out buyers despite troubled times—the new higher potential reward compensates them for greater uncertainty.

This doesn’t mean that a decline cannot continue or get worse; it just means that if prices decline further, expected future returns will climb even higher.  Your job as an investor is not to try and predict what will happen next and act on it.  It is to earn the full return that markets offer to achieve your long-term goals.  Suppose you mishandle declines or disappointing returns by shutting off your savings plan or selling out of it.  You will most likely turn a temporary drop into a permanent loss that could compromise your chances of financial success.

Remember Dimensional co-founder David Booth’s saying about temporary declines and the opportunity they create: “you’ve seen the risk, you might as well stick around for the reward.”

Are you struggling to create a sensible investment plan given the uncertainty of today? Are you finding it tough to stick to the plan that you have? Would you like to chat about your situation and whether Servo could help? If so, schedule a 15-minute call with me here.


Details of Dimensional Core Plus 100/0 Wealth Index available upon request.

Past performance is not a guarantee of future results. Index and mutual fund performance includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and should not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.