By Ernie Ankrim, Ph.D., Chief Investment Strategist
Russell Investments
August 2008

My children range in age from 26 to 30. They're all aware of President George W. Bush. They remember Bill Clinton. A few even remember George H.W. Bush. They've all heard of President Ronald Reagan. They view all the presidents before these as pretty much the same—historical figures that lived and died before the really important times in our country's history, which happen to be the years that represent their own experiences.

Investors demonstrate a similar attitude. Most can shrug off a bad day, week or even year in a market before beginning to worry that recent events call for a change in plans. They also believe that their investment experiences—whether over 5, 10 or even 20 years—are sufficiently instructive to form their expectations on market returns. In my conversations with investors in an adult lifetime of well more than 20 years, I've concluded that between three and five years experience is all that investors think they need to determine an accurate view of market risks and returns. This is myopic at best and dangerous at worst.

Today, many investors take a negative view of the equities market. This is easy to understand for investors who only recently began to observe markets and put assets at risk. From a short-term perspective—the last year or so—investors would conclude that this is as tough a market as we've seen. They might even think it best to get out and stay out—that the equities market means nothing but trouble. But they'd be mistaken.

It takes a far longer perspective to appreciate the wide range of return experiences possible from equity portfolios. To aid in the perspective I offer market illustrations covering the last 82 years.¹ This gives us a much more well-rounded view.

We'll examine some of the best experiences in the market and some of the worst, and see what we might learn. Then I'll "predict" what investors today are likely to do—at least based on past experience. We won't be able to live the experience of 82 years, but we can improve our understanding of the current market in a context broader than "since I've been here."

Standard Return Summaries: Good News
Historically, investors do well to buy and hold equities as a good portion of their portfolios. For the purposes of this article, we'll discuss index returns. While indexes cannot be invested in directly, they do serve as good proxies for the market. Annualized returns from 1926 - 2007 averaged about 10% as represented by combined data from Ibbotson Associates and the Russell 1000 Index®. That's quite attractive and beats inflation handily. But equities didn't rise in a straight line year after year. The numbers reveal that one-fourth of the years produced losses of -4% or more and one-fourth of the years produced gains of 27% or more. The remainder of the years produced returns between -4% and 27%.

82 years of U.S. equity market returns: 1926-2007

Source: Ibbotson Associates/ Russell 1000 Index®

Of course, the period from the late 1920s through the '30s—covering the Crash through the Depression—was dramatically more volatile than anything we've seen since. I hope we'll never experience that again. The late '70s offered another painful—if less so—period for investors.

But all in all, 1926 to the present provided a wide array of experiences that yielded attractive long-term returns punctuated by periodically frightening volatility. When viewed over shorter horizons, the markets have been overly generous or painfully punitive at different times. It all depends on which short-term periods you examine.

Five-year Periods: Getting a Grip on the Markets' Ups and Downs
If we look at just any single year in U.S. equity market history, we have no perspective at all. Only the most impatient investor would believe that 12 months of returns would be representative of a long-run trend. However, as I mentioned before, most investors I've talked with begin to get anxious—or euphoric—after three to five years of similar results. So let's start with five-year experiences—amounts of time we can get a grip on—to see what they tell us.

As part of my work for this article, I recorded the best and worst calendar-year return of each of the 77 different five-year periods these data provide. As an example, let's look at the five calendar-year equity returns from 1960-64.

In 1961, the market offered its best return of this five-year period—an attractive 26.9%. But there was pain, too. Look at 1962. The worst of the five years, it produced a return of -8.7%.

The average "worst" return for all the five-year periods is -12.1%. In other words, over the last 82 years, an investor with a five-year holding period would, on average, give back one-eighth of his or her portfolio in one of those "worst" years. This represents the pain of equity investing.

But historically, pain is accompanied by gain. For the 77 five-year periods our data covers, the average "best" return for all the five year periods was 35%. So on average, one year in five provided an increase in portfolio value of over one-third. This very generous gain generally offsets the "worst" year and then some. This is the periodic reward that is possible with equity investing.

Is there any way to enjoy the gain and without the pain? Probably not. When you're in the market, you're subject to its ups and downs. Sadly, many investors make decisions on being in or out—or more accurately, on what percentage of their portfolio will be in or out of equities—on the basis of their most recent investment experiences. This becomes very difficult when our recent experiences have been so unusual.

To highlight this conundrum, let's look at some recent extremes. The second highest "worst" year in a five-year period was 2007 with a 5.8% return. Compared to the average "worst" of -12%, a worst year of 5.8% sounds magnificent. The greatest five-year run by this measure was from 1995 through 1999 when the "worst" return was 20.9% (1999) and all returns from 1995-98 were higher. No other five-year period in our data comes close.

Wild Performance Leads to Poor Behavior
The 1995-99 experience detracted from, rather than added to, responsible investor behavior. Following five years of incredible market generosity, investors bought into equity mutual funds at an astonishing rate.² In fact, although investor inflows from 1995- 99 were twice the size of inflows in the previous five years, the inflows in just five months from January-April 2000 were larger than an average twelve months from 1995-99. In sum, money kept pouring into the market based on the belief that equities would always rise. Only readers with the shortest memories have forgotten the fate that awaited "irrationally exuberant" investors who jumped in at the end of the "dot.com" bubble.

The bubble burst hard! For the 36 months ending March 2003, the annualized returns to the Russell 1000® Index were -16.2%, the lowest in any 36-month period since July 1933. Worse yet, when the pain of these 36 months was nearly gone, investors took money out of mutual funds at a rate equal to nearly one-half a year's inflows (from 1984 up to that time). To continue this tale of investor-discipline woe, the market then advanced by 33.8% over the remaining nine months of the year. But investors mistakenly believed that their most recent experiences were their best guide to the future. Thus more money flowed into mutual funds in January 2004—after the 33% run—than in any month since the first two months of 2000. Those investors paid a price.

Of course, no single five-year period is "normal." Looking back over just the last ten five-year periods, the average "worst year was -10.1% (slightly better than the 83-year average). Yet in these ten observations, we've seen periods with a painless "worst" of +5.8% (2003-07), an excruciating worst of -21.7% (2000-04) and the all-time best "worst" return for 1995-99 of +20.9%. These times have posed serious challenges for investors' patience and discipline.

Lessons to be Learned
The first lesson from these data should be: There are few, if any, current market events that should cause long-term investors to dramatically alter their portfolios. Stay with it. Investment experiences that occurred before you got in are relevant to what you should expect ahead. In the end, these historical experiences can be sources of strength when the wisdom of your portfolio structure is being tested.

Here's another key lesson: Every mutual-fund prospectus must state, "Past performance is no indication of future results." This is true. Unfortunately, past market performance appears to be related to investor behavior. Too many investors get out of equities when the market heads south or rush in when returns have been great. But as we've seen, even good five-year periods include bad years. Moreover, disappointing periods may still provide unexpectedly good return runs.

Investors who believe that every new environment demands a new investment strategy generally do more harm than good to themselves and their portfolios.

Our Latest Experiences
How does our most recent equity-return experience stack up to those of the last 15 years as well as those of the last 83? First, we continue to travel in uncharted waters. Unless we see a big rally from this September-December, the five-year period from 2004-08 will offer the lowest "best of 5-years" return ever—only 15.5% in 2006. The previous all-time low was 19%.

If the market stays at its present level, it will be down about 11% for the year. How bad is that? It would be slightly better than the -12% average "worst" year-of-five we've seen. This reveals that we haven't seen a historically horrible downside during this period. What has made the last few years difficult is that we haven't seen a great upside, either.

I recognize that investors skeptical of the rewards related to risk have recent evidence to support that view. In the not-yet-complete decade of the 2000s, bonds have outperformed stocks. If this continues through 2009, it will mark only the third decade of the last eight when this has happened. Only in the 1930s and 1970s did we see such a development.

It is therefore useful to ask: Going forward, will investors take on more risk, take on less, or stay with their current risk level? Given the economic stresses and modest equity returns of recent years, it's reasonable to expect that more investors will employ one of these three strategies:

1. Seek exotic investment vehicles claiming better returns with lower risk
2. Look for lower risk/return investment options as a new, long-term strategy
3. Reduce equity exposure now and plan on returning when prospects look better

All three strategies come with their own costs. First, I believe we'll continue to see innovations in investment products, but the ultimate trade-off between risk and return will persist. Every period of investment stress produced some vehicle that seemed like the new answer. But investors found out the hard way that often these products were poorly suited for a change in the environment.

Second, the greatest threat to long-term investors' wealth is the reduction in purchasing power that comes from elevated rates of inflation. Clamping down on portfolio risk increases the chances of losing ground to inflation.

Finally, it's worth repeating that risk and reward go together. Only exposure to risk enables us to capture higher returns unless we have a magic timing process and know when the market will go up and when it will go down. I can't emphasize strongly enough—relying on timing peaks and troughs is very risky, with few examples of success.

Two Critical Approaches
As an investor, you need to do two things. First, maintain a balanced portfolio to ease shocks when asset classes or sectors take a tumble. Second, stay invested in equities during down years. Over time, they have outperformed bonds and beat inflation.

In this regard, let me offer one "guarantee": Investors on average will continue to act as if the only relevant investment experiences they require can be drawn from the last three, four or five years. I encourage you to commit yourself to being different than average and to taking the longer view.

And remember: No one can accurately predict what the future holds by observing what has happened during the last two to five years. It takes a broader perspective on market history to develop a reasonable sense of the range of possible outcomes. We have the numbers. Use them. Investors must keep in mind all that happened before and after they began investing. This is the key to designing portfolios for the next 5, 10 or 20 years.

As a twenty-something, I believed that relevant history really began when I was in the midst of it. I learned that perspective matters. Call it wisdom, maturity or perspective—but just be sure you call on it as you fashion your investment strategies and behavior.