Expert Guidance: Managing expectations With Jeremy Siegel, The Wharton School Managing expectations J.P. Morgan, the legendary turn-of-the-century American banker, was often asked what the stock market's next move would be. He responded "It will fluctuate!" Although most investors readily accept this answer on an intellectual level, the volatility of the markets is far harder to deal with emotionally. One can say confidently, "Of course I understand the market goes down as well as up." But plummeting averages and increased media coverage induce a fear that causes some investors to flee to the safety of short-term assets, such as money market accounts and certificates of deposit.

Public enthusiasm for investing in stocks tends to come and go in cycles that echo the market's own rhythms. When the market rises for a sustained period of time, the idea that stocks can suffer serious declines tends to be dismissed by some investors as an old-fashioned notion that may have applied in previous eras but has no relevance to the current one. Conversely, a real bear market — that is, a decline of 20% or more that stretches over a number of months or even years — demoralizes many investors so thoroughly that they lose sight of the favorable long-term outlook for stocks. In short, extremes in stock price movements distort the expectations of a large percentage of investors, except for those who are able to look beyond the short-term.

"Managing expectations" is designed to demonstrate what you can realistically expect from holding stocks and provide you with a plan for dealing with market volatility. You don't have to "beat the market" to do well in stocks. Success comes with persistence and the ability to harness your emotions when volatility strikes. Winning with stocks requires only patience, not foresight.

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Investor expectations

A big part of succeeding as an investor is having the right expectations about what you can achieve by putting your money into stocks, bonds, and cash, or the mutual funds that invest in them.

It's not a big secret that people invest because they expect to make money. Indeed, many succeed. But others are disappointed either because they overestimate the return they are likely to get or because they are unwilling to risk any of their principal to earn a higher return.

As you invest to meet your financial goals, it's critical to understand what buying securities can do for your net worth — and what it may not be able to do.

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Investor confidence

Many people have become familiar with the basics of investing and have developed their skills as investors participating in retirement plans such as 401(k)s at work, individual retirement accounts (IRAs), and college savings plans. For many, the sterling returns of the 1990s bull market reinforced their positive view of what investing could mean to their financial security.

Further, the high media profiles of the Securities and Exchange Commission and the Federal Reserve, which oversee the securities industry and the banking system respectively, have reinforced the public's confidence in the integrity and stability of American securities markets.

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The financial media

Constant media attention has also encouraged growing familiarity with the securities markets. There has never been more information — and misinformation — available to investors and potential investors. You can follow minute-by-minute changes in the price of a stock on television and on the Internet, in a way that only investing professionals could in the past. And the unprecedented run-up in stock prices in the 1990s spawned thousands of publications, television shows, and Web sites of varying quality devoted to investing and personal finance.

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Celebrity analysts

Investment advisers and celebrity analysts have encouraged the public's interest in the securities markets. While the majority of professionals are conscientious about the messages they deliver, a few either wittingly or unwittingly have encouraged investors to develop unreasonable expectations for their stock market portfolios.

For example, during the bull market of the 1990s, many individual and professional investors came to expect ever higher stock prices and soaring averages, despite the fact that, in retrospect, company fundamentals, the country's economic outlook, and past experience indicated that it wouldn't be sustainable.

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Historical performance

Despite all the investing information that's available — or maybe because of it — it's unclear how many investors really understand the constant fluctuations of the securities markets, and what they can reasonably expect to earn on their investments.

It's true that historical trends show that over time securities, stocks in particular, tend to go up in value. But the shorter the time horizon, the more difficult it is to predict — even for investment professionals — what direction the market may be headed. Only one thing is certain: The values of securities will go up in some years, just as surely as they will go down in others.

What can help ensure that your expectations are in line with reality is understanding the history of investment market performance and how to use market benchmarks as a measure of current performance.
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Understanding risk

It's important not to expect too much from the securities market — such as double digit returns on your investment every year or a portfolio that never loses value. However, it's equally important not to expect too little.

If you invest very conservatively — or don't invest at all — because you fear losing some of your principal, you run the risk of not meeting your goals and even running out of money during retirement.

Investing almost always entails a certain amount of risk. But that doesn't mean taking on risk blindly — it means anticipating what the risks of a certain investment are and having a strategy in place to manage, or offset, them. Understanding the ways different types of investments have performed historically can help you gauge what you can reasonably expect as an investor, and manage your portfolio accordingly.

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Are stocks risky?

Stocks have a reputation for being volatile investments. And over the short-term, there is a lot of truth to this. For example, after accounting for inflation, large-cap stocks as a group lost almost 39% in 1974 and gained over 30% the following year, in 1975. In 1990, small-caps lost almost 28% but gained over 41% in 1991, after inflation. That's a comparatively broad fluctuation in value for both large-cap and small-cap stocks over a two-year period.

Compare this to Treasury bills, which — in a strikingly volatile period for T-bills — lost 1.16% in 1980 and gained 5.77% in 1981 after accounting for inflation. Compared to stocks, that's a very narrow fluctuation in value.

In general, stocks have the potential to change much more sharply in value over the short-term than fixed-income securities, such as bonds and Treasury bills.

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Long-term returns

But an interesting thing starts to happen when you look at the after-inflation performance of stocks over longer holding periods — say 5, 10, 20, or 30 years.

In every 5-year holding period since 1802, the worst performance in stocks, at -11% after inflation, has only been slightly worse than the worst performance in bonds or bills, at -10% after inflation, although they have the reputation of being stable investments.

Over every 10-year holding period, stocks have always outperformed bonds and bills — never losing more than 4.1% — while bonds and bills have lost 5.4% and 5.1% respectively.

Over every 20-year holding period since 1802, stocks have always had a return higher than the rate of inflation, while bonds and bills have fallen 3% per year behind the rate of inflation for this period. (A 3% annual loss over 20 years wipes out half the purchasing power of a portfolio.)

For 30-year periods, the worst annual stock performance remained ahead of inflation by 2.6% per year — that's just below the average 30-year return on fixed-income assets.

There is no guarantee that the stock market will continue to perform in the future as it has in the past. But since 1802, stocks have outpaced every other asset class over every holding period of 10 years or more, and have beaten inflation over every period of 20 years or more.

Although it might appear to be riskier to hold stocks than bonds, precisely the opposite is true: Stocks are the safest long-term investment if what you want to do is preserve your purchasing power and build the value of your portfolio.

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Holding periods

Past performance shows that stock investors with 20 years or more to invest have an extremely good chance of not only beating every other asset class, but of also beating inflation. This is an especially powerful argument for long-term stock investing when you realize that these figures aren't for holding only the top performing stocks, but for holding stocks as an asset class , regardless of how many times you change the individual issues in your portfolio. (This doesn't mean, of course, that you can't lose money on a particular stock if it's been in your portfolio for 15 or 20 years.)

And while 15 years or more may seem like a very long time, it really isn't when you consider that the life expectancy for women at age 65 is more than 20 years, and for men is more than 16 years. Indeed, it's not uncommon for people who begin investing in their 30s to remain invested for over 45 years. And even people who begin investing in their 40s or 50s may stay invested for 20 or 30 years, or more.
From the expert
Jeremy Siegel of The Wharton School describes the benefits of a long-term investing strategy.

The lesson of history is that those who are willing to commit to a long-term investment program in stocks are unlikely to lose their investment capital and, in fact, are likely to add significantly to it. The trick is to stay invested even when the market is moving against you, and to use diversification to damp down risk to a level you can live with.
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Inflation & return

When evaluating the potential return on your investments, it's important to look at the impact of inflation on the returns of different classes of securities. If your investment isn't outpacing inflation, then the purchasing power of your capital is shrinking rather than growing.

For example, the yield on Treasury bills has never been lower than it was in 1938, at -0.02%. However, after accounting for the impact of inflation, 1946 was the worst year to be invested in T-bills. Although the yield was a very modest 0.35%, the inflation rate that same year was over 18%. That means that in terms of actual buying power, the value of a T-bill investment dropped by over 17%.

The picture changes slightly over the long term. Between 1926 and 2003, Treasury bills returned 3.8% compounded annually, before accounting for inflation. But the real rate of return — or inflation-adjusted return — was only 0.8% annually. What this means is that while a dollar invested in Treasury bills in 1925 was worth $17.66 by the end of 2003, in terms of actual buying power it was worth only $1.72 by 2003.

These figures demonstrate that while investing in T-bills may be a sound technique for preserving capital, historically they have fallen short as growth investments. In fact, over the long term their return has barely outstripped inflation.
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Inflation & stocks

In contrast, the total return — or unadjusted return — on large-cap stocks during the same time period of 1926 to 2003 was 10.4% compounded annually, while the inflation-adjusted return was 7.2%. That means that a dollar invested in large-company stocks in 1926 would have been worth $2,284.79 before inflation but $222.23 in terms of actual purchasing power at the end of 2003.

As you can see, inflation can have a major impact on investment return. If you expect your portfolio to grow, you’ll need to invest in securities that have a good chance of outpacing the average yearly inflation rate of 3% per year.
From the expert
Jeremy Siegel of The Wharton School explains how stocks can help offset the impact of inflation.

The focus of every long-term investor should be the growth of purchasing power — monetary wealth adjusted for the effect of inflation. It is clear that the growth of purchasing power in equities not only dominates all other assets but is remarkable for its long-term stability.

On average, the purchasing power of assets invested in the stock market has doubled every ten years. Based on returns of the last 75 years, it would by contrast take 40 years to double one's purchasing power in bonds and 120 years to do so with Treasury bills. Page 12 of 22

Inflation-adjusted returns

In general, historical inflation-adjusted returns provide a realistic gauge of how you can expect your investments to perform over the long term. This does not mean that year in and year out your investments will meet — much less beat — past returns. In fact, you can realistically expect that some years your investments will significantly underperform the historical averages, and you’ll even lose money. In other years, you may handily beat the average annual inflation-adjusted returns.

There are no guarantees that your long-term investments will perform as well as similar securities have historically. Nonetheless, historical returns have been consistent enough to provide a sound idea of what you can reasonably expect as an investor.
From the expert
Take a realistic look at long- vs. short-term investing.

It's important to maintain a clear distinction between long-term and short-term investments. There's a trap that many investors fall into as the market surges upward month after month. It all seems so easy. In such circumstances, it may be tempting to withdraw funds from your money market accounts or refinance your house to invest in stocks. Think very carefully before doing these things. You still need a short-term, emergency source of cash. You still need a house. Both could be jeopardized if you plunge into the market at the wrong time. Remember that market risk increases as you shorten your investment time frame. If it's money you might need in less than five years, you're probably better off leaving it where it is.Page 13 of 22

Irrational exuberance

It's generally true that the higher stock prices are, the more optimistic investors become, and the lower prices are, the more pessimistic they become.

It can be difficult — even for the most experienced investor — not to get caught up in the prevailing enthusiasm or pessimism of the moment. Take for instance so-called irrational exuberance — popularized by Fed Chairman Alan Greenspan in his 1996 warning about the booming stock market — which has come to characterize the unrealistic expectations of many investors of the late 1990s.

Many individual and professional investors came to count on 25% or higher annual returns on their investments in the absence of company earnings, historical precedent, or any economic indicators to warrant such optimism. Some market commentators were even rewriting the rules for measuring the value of stocks, saying the traditional wisdom for evaluating the soundness of companies no longer applied.

The more cautious were vindicated when the downturn in stock prices in 2000 and 2001 proved that company fundamentals — such as earnings, management, and the strength of a company's product — not only mattered but had major consequences on the markets.
From the Expert
Jeremy Siegel of The Wharton School recalls other instances of irrational exuberance.

The bull market of the 1990s was not the first time investors succumbed to the tantalizing notion that the rules of the game had been rewritten to exclude failure. They did so in the 1920s, and in the 1960s. In the 1980s, Japan served as the example. When the president of the Chicago Mercantile Exchange, who was visiting on a business trip in 1987, expressed amazement at the high valuation of Japanese securities, his hosts replied, "You don't understand, we've moved to an entirely new way of valuing stocks here in Japan." The TOPIX index — the Japanese equivalent of the Dow Jones Industrial Average — subsequently fell from over 2881 at the end of 1989 to 1722 at the end of 1999, roughly a 40% drop. Page 14 of 22

Speculative bubbles

There have always been speculative bubbles — periods when stock prices have risen to unsustainable levels on investor optimism. The late 90s was one such period, as were the bull markets of 1970 to 1972 and 1982 to 1987.

Usually, a period of very high stock prices is followed by a period of depressed prices. Stocks become under valued — or fall lower in price than a company's prospects would seem to warrant — when investors overreact to negative news, such as a company profit warning, rising interest rates, or political or economic upheaval at home or abroad.

Historical evidence demonstrates that stock prices eventually readjust to levels that are more in line with their actual value — and more in line with historical norms. While the ups and downs can be unsettling, they may actually reward the patient, long-term investor who takes advantage of the opportunity to purchase high-quality, undervalued stocks at discounted prices.

Tulip Bulb Mania

Speculative bubbles have recurred throughout history. Tulip Bulb Mania in 17th-century Holland is a particularly colorful example. The flowers — newly imported from Turkey — became an instant hit, and many people abandoned their families and livelihoods to get in on the craze and cultivate tulips in hundreds of different sizes, shapes, and colors. Tulip bulbs traded on exchanges at ever blossoming prices — one rare specimen sold for the equivalent of $150,000 by some accounts — as people staked everything they owned to invest in the bulbs. When the craze wound down and prices plunged, many families were left penniless. Today a bag of tulip bulbs costs around $3.00.
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Anticipating volatility

As an investor it's important that you stay grounded during good times. But it's equally important that that you don't shy away from stocks and put all of your money into cash equivalents, such as certificates of deposit or money market accounts, every time there's a slump in the market. You stand a poor chance of outpacing inflation over the long term if most of your assets are tied up in fixed income securities and cash equivalents. And one sure way of losing money in the stock market is to pull your money out — and lock in your losses — at every downturn, only to buy your way into the market again after it's already bounced back.

As an investor, it's wise to expect fluctuations in the value of your portfolio. Just keep telling yourself that the market has consistently rewarded the patience of long-term investors who stay in the stock market for 20 years or more.
From the Expert
Jeremy Siegel of The Wharton School explains mean-reverting returns.

To properly evaluate the risk of stock investments, it's necessary to grasp a key principle: the longer you hold stocks, the lower your chances of losing money on them, and the greater your chances of earning a return close to the long-term average of 7.7% after inflation. That's because stocks have historically had what economists call mean-reverting returns — that is, over the long term, periods of below-average returns tend to be followed by periods of above-average returns, and vice versa. Page 16 of 22

What investors can't predict

You may be familiar with the following disclaimer: "Past performance is no guarantee of future results." The Financial Industry Regulatory Authority (FINRA), which oversees the securities industry, requires this disclaimer on all investment advertising and marketing materials.

Because the historical record for long-term investing is remarkably consistent, it can be an excellent foundation for setting expectations and making investment decisions. However, the disclaimer serves as an important reminder that while the past record is impressive, there are no absolute guarantees that you will come out ahead.

The securities markets don't always work in predictable ways. New precedents can always be set. There are many forces that can have a negative impact on the markets — for instance, political turmoil at home or abroad, changing interest rates, disappointing economic forecasts. As an investor, you almost always have to learn to deal with a certain degree of uncertainty. The good news is that time and the historical record are solidly in your favor.
From the Expert
What does Jeremy Siegel of The Wharton School have to say about planning for the unpredictable?

For planning purposes, it's best to assume that the market will continue to operate as it has in the past, and that you will be faced with one or more substantial declines during your investing lifetime. You should know how you will react to those declines. In order to receive the benefit of long-term returns, you need to be invested through the market's valleys as well as its peaks.

If after an honest self-appraisal, you feel you can't stand the risk inherent in the stock market's short-term swings, talk with a qualified financial planner or investment adviser, who can help you tailor an investment program to your individual needs. Page 17 of 22

Market benchmarks

You've learned to accept the ups and downs of investing in the stock market. You understand that even sound, high-quality investments can fluctuate in value — sometimes significantly. Then you may be asking yourself how you can gauge how well you're doing as an investor, if not by any absolute measure of annual gains or a portfolio that never loses value.

This is where benchmarks can help. A benchmark is an index, average, or other measure, the movement of which serves as a standard, or basis of comparison, for evaluating the performance of the overall market. Investors and financial professionals use benchmarks as a gauge against which they set their market expectations, and judge the performance of individual securities, market industries and sectors, and the performance of different securities portfolios.

The Standard & Poor's 500-stock Index (the S&P 500) and the Dow Jones Industrial Average (the DJIA or the "Dow") both track the performance of large-cap stocks and are the most widely followed benchmarks of the U.S. stock market. There are also benchmarks for international markets, different subclasses of securities, for instance small-cap stocks, and for other types of investments such as bonds and mutual funds. Sometimes current yields and interest rates are used as benchmarks — such as the yield on the 10-year Treasury note for fixed-income securities and the current interest rate for 30-year mortgages.

Popular benchmarks
Bonds and other fixed income investments	Current 10-year Treasury note yield Lehman Brothers Intermediate Government/Corporate Bond Index
The NASDAQ Stock Market®	NASDAQ Composite Index
Technology stocks	Goldman Sachs Technology Index
Overall market	Wilshire 5000 Index
International stocks	Morgan Stanley Capital International Europe, Australasia, Far East (EAFE) Index
Japanese market	Nikkei Index
Mortgage rates	Current interest rate

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Using benchmarks

Benchmarks can help you gauge how well your investments are doing against the overall market.

For instance, if your U.S. small-cap mutual fund dropped 5% in value in a year when the Russell 2000 Index — considered the benchmark for small-cap investments — gained 10%, it may be time to reconsider your investment choices. Of course, you may want to give your investment a couple of years to meet your performance expectations. But if your investments are underperforming the corresponding benchmarks year in and year out, then it's probably time to evaluate your other options.

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Using benchmarks correctly

One mistake you want to avoid is measuring the performance of one asset class or subclass against the benchmark of another. For example, let's say that one year the Russell 2000 Index — the benchmark for small-cap stocks — gained 12% but your individual blue chip stock holdings gained an average of only 2%.

While the Russell 2000 can tell you something about the overall performance of small-caps, it can tell you very little about the performance of your blue chip portfolio in comparison to the rest of the large-cap market. Indeed, from one year to the next, large-cap and small-cap stocks can significantly outperform each other — which is why it can be smart to own both in your portfolio.

To get an accurate sense of how your large-cap investments are doing, you would have to measure them against a large-cap benchmark, such as the S&P 500 or the Dow.

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Economic indicators

Similar to the way that benchmarks can help you gauge the performance of your investments against the overall market, economic indicators can give you a sense of the broader economic outlook. Economic indicators are key statistics published monthly by The Conference Board. Changes in those numbers are used to forecast the direction of the economy — approaching downturns in particular. Key economic indicators include consumer confidence, the unemployment rate, the inflation rate, productivity rates, gross domestic product, and the balance of trade.

It can be a good reality check to evaluate the performance of the markets in light of these statistics. For example, if stock prices are soaring in the absence of comparable economic growth — as indicated by a substantial increase in gross domestic product, high productivity, low unemployment, and other indicators — chances are that these high prices may not be sustained. On the other hand, if stock prices are depressed while the economic indicators forecast positive economic news, the markets may be poised to bounce back.

Of course it's always risky to try to time your investment decisions based on economic forecasts, and historically the markets have rewarded long-term, buy-and-hold investors. But these statistics can help you gauge to what extent the markets may be undervalued or overvalued at any given time, and help you adjust your expectations accordingly.
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Hindsight is 20/20

To be a successful long-term investor is easy in principle, but difficult in practice. It is easy in principle since buying and holding a diversified portfolio of stocks is available to all investors. Yet it is difficult in practice since tales of those who have quickly achieved great wealth in the market tempt many people to play a game very different from that of the long-term investor.

People who follow the market closely often exclaim: "I knew that stock (or the market) was going up! If I had only relied on my judgment, I would have made a lot of money." But hindsight plays tricks on our minds. We forget the doubts we had when we made the decision not to buy. Hindsight often distorts the past and encourages us to play hunches and outguess other investors, who in turn are playing the same game.

For most of us, trying to beat the market leads to disastrous results. We take far too many risks, our transaction costs are high, and we often find ourselves giving into the emotions of the moment — pessimism when the market is down and optimism when the market is high. Our actions lead to substantially lower returns than can be obtained by just staying in the market.

Achieving good, long-term returns is simple and available to all who seek to gain through investing. There are several fundamental strategies, such as asset allocation and diversification that may help you increase your returns while minimizing your investment risk.

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