What Returns Should We Expect From Stocks?

I read yesterday on Morningstar that the Vanguard US Total Stock Index is the first mutual fund to surpass $1T in assets.  So investors are certainly expecting a lot from US stocks, and the large cap growth and technology stocks in particular that dominate the US index.  But what’s realistic?  Should we go by the last few years, where large US stocks with the highest prices have surged while small cap and value stocks have slumped?  Or does history give us a better idea?

Let’s start the long-term historical index data.  If recent returns are similar to history then we might expect trends over the last few years to continue. 

From 1928 through 1994, all US stock categories did well, but lower-priced value and small cap asset classes did better.  The DFA US “Total Market” Index gained +9.7% per year (this is where the “stocks earn 10% a year” comment comes from), but lower-priced large “value” stocks did better, the DFA US Large Value Index returned +11.2%.  Small stocks did even better — the DFA US Small Cap Index gained +11.9%, and the best performing asset class overall, with almost a 4% higher-than-market return, came from small value stocks, earning a whopping +13.2% per year.  

The evidence from history is clear: holding a diversified stock index is a great approach for long-term growth, but focusing on lower-priced value stocks and smaller cap stocks gives you the opportunity for much greater returns.

Starting in 1995, we have live mutual funds that track these various areas of the market, not just in the US but in international markets as well.  So it makes sense to see what stock returns have been when investors were able to directly invest in these categories with their savings.  

The next 19 years, through 2013, produced returns that were quite remarkable in that they were strongly positive, but also they were identical to the historical data!  The table below provides the details — once again, the stock market (Vanguard Total Stock Market Index) gained almost 10% a year, while value, small cap, and especially small cap value stocks did far better.  The biggest discrepancy between the historical index data and the 1995-2013 live data came from small cap value stocks, and even here the difference was only 0.22% per year higher returns in the recent data!

But then 2014 hit, and the world as we understood it seemed to change.  Large US stocks have performed better than average, earning almost 11% a year, helped by a handful of technology companies in particular (Facebook, Amazon, Apple, Microsoft, Google, Netflix, and now Tesla) registering +30%, +40%, even +50% a year returns.  

The value and small cap asset classes that had produced higher long-term returns for almost 90 years have languished.  In the extreme, the best performing asset class — small cap value — barely had any return for the last seven years through September!  

We’ve seen extreme market environments before, but the spread between US large growth stocks and small value stocks has never been wider than it has been recently.  Many investors who once believed in diversifying their portfolios into smaller and more value-oriented stocks have given up, moving all of their holdings to the Vanguard Total Stock Index instead of using it as just one position (the “large cap growth” asset class) in a well-diversified asset allocation.  They have once again proved the old adage that investors (not the market) are their own worst enemy!

They might be right, these Total Market “Johnny-Come-Lately’s,” if recent returns continue.  But there is nothing about the last seven years in the stock market, or the economy, that leads to the expectation that the largest, fastest growing companies should have the highest long-term returns.  This time isn’t different.  Large growth stocks are the safest companies, certainly compared to smaller and lower-priced value stocks stocks, which are often in underperforming industries, with weaker historical and future earnings prospects.  Importantly, in investing, the iron rule is that safety means lower returns, and higher risk means higher returns.  We see this play out in the relationship between lower-returning bonds (“safer”) and higher-returning stocks (“riskier”), the same holds true for the types of stocks you own.  Safer/lower returning investments can, for a time, produce higher returns.  But it never lasts.  Older investors who lived through the 1990s technology bubble can attest to this.

So the weight of the research and evidence, prior to 2014, is behind asset class diversification and tilting to small cap and value stocks in long-term investment portfolios.  Unfortunately, economic and asset pricing theory are interesting, but hard to put real dollars behind.  We’d prefer to see actual results before we wholeheartedly embrace theories with actual money.  

Fortunately for the skeptics, we’ve seen an epic reversal in asset class returns this quarter.  And I mean epic.  These results don’t come close to offsetting the lopsided returns from the last seven years, but you can image another year or two of these dramatic return differences in favor of small cap and value, and the world will once again look the way it always has.  Wouldn’t that be nice?

From October 1st through December 15th, the table below reports a strong return overall for stocks — the Vanguard Total Stock Market Index Fund has gained +12.8% in just 10 weeks.  But large value stocks have done far better, +17.7%.  Small cap stocks are up a tremendous +27.6%, and small cap value stocks are up most of all, the DFA US Small Value Fund has gained +31.6%.  If the quarter ended yesterday, this would be the 2nd best three-month period for small cap value stocks in almost three decades!  Proof, once again, that stock returns come in short bursts, and you have to be patience and disciplined to earn them.  Unfortunately, very few investors are.

But back to our original question…what returns should we expect from stocks?  If I were to answer this question a few months ago as I am about to, you likely would have been far more skeptical than you are today.  

I think long-term historical results are a pretty good guide to the future.  Not just the absolute figures, but the relative results as well.  +9% to +10% a year for US stocks is reasonable.  +11% to +12% a year for large value and small cap stocks, and something north of +13% a year for small cap value stocks.  These results won’t come smoothly and we will rarely if ever hit these figures in any given year.  But over a full market cycle, these are reasonable bets.  They are certainly more reasonable than the predictions that stock returns will be materially lower, or higher, than what they’ve been.  

What’s also a safe bet is if you are one of these investors who has all of your stock holdings in a Total Stock Market Index Fund, you’re going to be sorry you weren’t more diversified.  Setting aside the importance of international diversification, adding large value and small value asset classes can help propel your portfolio to returns that are +1% to +2% a year more than simple indexing.  You might need every ounce of these higher returns to retire on time or to generate all the money you’ll need to live to a ripe old age.  Much of your possible legacy that you will one day leave behind might also come from these premiums.  Simply put — regardless of your goals, you don’t want to miss out on the higher expected returns from small cap and value stocks.

For planning purposes, you might want to knock a % or two off those figures if for no other reason than if you do get lower returns, and are prepared for it, you’ll still be OK.  If not, you might come up short.  If you want to use +7% to +8% (US large cap/market), +9% to +10% (large value and small cap), and +11% to +12% (small value) instead when you are projecting how much you’ll need to save for retirement or how much you can spend in retirement, that’s OK.  But history has shown us that long-term returns are a pretty good guide to future results if we wait long enough.  Given the huge discount in terms of price to earnings or book values that small cap and value stocks trade at today compared to large growth stocks, the historical relationship between large/small and growth/value also seems to be at least as good a guide to the future as well, if not a bit conservative.  

Stay disciplined, and let’s hope the small cap value resurgence of the last few months has legs.  But above all, let history’s returns guide you, and stay optimistic.  That rarely fails.


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.