The Trick To Estimating Your S&P 500 Returns

The Trick To Estimating Your S&P 500 Returns
Luke Suddards

about 1 year ago2 mins

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The recent bear market has sent valuations for the S&P 500 sliding downward, and you should pay close attention to that. See, a stock’s valuation plays a crucial role in determining your long-term returns: Bank of America’s (BoA) research shows that valuations – that’s normalized price-to-earnings (P/E) ratios in this case – explain a whopping 80% of the variation in future 10-year S&P 500 returns. Put simply, the lower the P/E ratio, the better your odds for higher future returns. And based on market cycles dating from 1987 to today, BoA’s model predicts annualized price returns of roughly 5% based on the S&P 500’s current 22x P/E ratio. Factor in a 2% dividend return, and you’ll get total returns that sit around 7%.

BoA’s research backs up another well-known adage: time heals all wounds, even in investing. “Time arbitrage” means that a longer time horizon usually lets you capture additional returns, and lowers your risk of negative ones. Case in point: tracking data back to 1929, S&P 500 returns were negative 10% of the time when holding for a 5-year period, and just 6% of the time for a 10-year period. After all, timing markets is notoriously difficult, and panic-selling during crashes can make you miss the best market days as they often quickly follow the worst. And since the 1930s, if you weren’t invested during the 10 best days per decade, your returns would be just 30% versus roughly 18,000%.

So while it’s tempting to hit the sell button when a big crash happens, decades of historical data tells us to sit tight. As Baron Rothschild once said, “the time to buy is when there's blood in the streets: that simply means buying more than you sell when prices turn cheap. After all, building a diversified portfolio across multiple asset classes could help soften the psychological effects of taking more losses in your stock portfolio.



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