Relying on stock market averages

In my research putting together my articles on Asset Allocation in Super, I’ve collated the data that supports the thesis that investing in Australian shares is not as lucrative as the financial industry would have you believe.

The standard industry myth is that the stock market provides 9% returns on average. I’ll quote broker Marcus Padley whose presentation last year got me thinking more in this direction:

If you just rely on the average return from the stockmarket, you are probably going to go nowhere in real terms (i.e after inflation, fees), yet there’s a whole swathe of people in my industry, advisers, brokers, financial planners who have got this idea that they genuinely believe that the average return on the stockmarket is something like 9.5%, that you’ll double your money every six years and triple it every 10…. You have to be smarter than that.

In the long run, we’re all dead
First, I’ve created a table of long term averages. That is, the average yearly return (using monthly average prices) from investing in the Australian share market since 1901, in 10 year intervals, up to 1986 and then 5 year intervals thereafter.

I’ve included the average dividend yield (could not find data before 1950, so I’ve used the average yield from 1950-2010 as a proxy), average inflation (according to the RBA, adjusted for decimilisation in 1966) and I’ve assumed – which is rarely mentioned – that you will pay 0.2% in slippage or dealing costs and on average 0.5% in financial planning and/or fund management fees. I have not taken into consideration survivorship bias, nor market entry, assuming that units in an index fund are purchased at monthly or quarterly intervals.

I also haven’t assumed tax implications, which confuses the matter in super particularly with regard to dividends and their franking credits, but this research is putting into light the “buy and hope” strategy, so tax on capital gains shouldn’t be an issue.

First off, the average nominal capital gain is nowhere near 9% per annum – although there has been a maximum of 49%, and a minimum of -29%. The long term average is 6.7% – and has been 5.3% since 1991.

Let me repeat that – the average nominal annual capital gain in the Australian stock market since 1991 has been less than 5.5%

Dividend hugging
Whoops – I forgot dividends, which have averaged since 1950 at 5.4% per annum, although since 1991 the average yield has only been 3.9%.

Add the two together and you are getting the much touted 9% average annual growth, so maybe I’m wrong.

But now we come to the crux of the matter – this result is before inflation and the inevitable slippage and fees charged to get access to this performance.

Inflation and taxes but I repeat myself
I’ve had to use the ABS derived Consumer Price Index, showing average annual “inflation”. Suffice to say, I think this measurement is baloney – it doesn’t really capture the reduced purchasing power of your capital, but its the only measurement we’ve got.

Using this data and a conservative assumption on slippage/dealing charges, plus fund management/financial planner fees, you can derive a pre-tax, but real average return since 1901 of 6.7% per annum. And that trend is turning down as we end this secular mega-bull market.

Remember, this includes dividends. Good, but not quite 9.5% is it?

Note that since 1981, where I’ve seen financial institutions spruik an average as high as 13%, the real return is 6.5% – and in the last 5 years its been 4.2%, including dividends (note the last cell)

Bonds, I presume
How do bonds stack up against this “performance”. Using the UBS Bond Index (data for which goes back to 1980) as a proxy, I’ve compared the two, and assumed less slippage and fees (as these are “passive” investments – most fixed interest options have very low management fees).

Obviously, bonds should not perform as highly as shares, but the outperformance is not as great as you would expect, given the substantial risk of loss of capital on the latter during any of the rolling periods, which I’ll come to shortly.

Bonds have managed a real, inflation-adjusted average annual return of 3.1% since 1981 compared to 6.5% for shares. This outperformance has reduced significantly in the last five years to only 1.8% – not a high premium. And crucially, we haven’t talked about the non-normal distributions around these “average” returns yet.

Rolling, rolling, rolling
Observing how markets perform over the very long term is interesting academically, but what about rolling periods that capture the volatility that is smoothed out by the averages?

Q Continuum made a point in his post on sideways markets that share markets move sideways, up and down, each about one third of the time. In some cases however, this sideways movement can last years or a decade. Note that the S&P500 US Share market moved sideways, from 1969 to 1982. Our market behaved in a similar fashion.

Note that there was another similar period in the 1950’s, after the post-WW2 euphoria ended, and over 5 years of zero nominal gains set in. Pundits may well point to the succeeding years of high double digit rises in stock market values, but fail to point out the commensurate rise in inflation.

The table above shows a period of 30 year rolling timeframes, similar to what a new superannuant would be exposed to in building their “savings”. Note how average inflation has been increasing over time, shadowing the increased “returns” of the sharemarket, whilst average dividends are falling.

The last 30 year period (1981 to 2010) has been one of the best performing in Australian history, mainly due to the bubble in stocks from 2003 to 2007, but the larger or secular trend has been obvious since the end of the decade long stagnation in stocks in 1982. During that period it was a reliance on dividends pushed by inflationary pressures that kept stock holders in the black.

I hope this small study of share market averages will give you an idea where we stand from an historically viewpoint. To summarise:

  • the average real return of the Australian stock market, after inflation, before tax is 6.7% per annum since 1901
  • the average annual dividend yield since 1950 is 4.8% and is declining
  • the average premium of stocks over bonds is 3.3% per annum since 1981 and is converging
  • the average nominal annual capital gain in the Australian stock market since 1991 has been less than 5.5%

This isn’t the complete picture, as this illustrates the potential returns available from the stock market, given some fairly conservative assumptions (e.g low fees, slippage and non-discretionary timing of entry, and most important – no effect from taxation and survivorship bias). It also doesn’t show the true potential and comparison with individual stocks, which can achieve many multiples of the averages above. Even some standout blue chips that comprise the index can outperform the average handsomely.

I’ll leave that discussion for another day.

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  1. Interesting article.

    Maybe I’m in the minority, but I thought it was common parlance to quote returns before adjusting for inflation. If that’s the case the 9% is about right. I think also that too many people assume that they can put money blindly into the ASX20/50 and make 10-13%+/year. The real growth is in small cap stocks. It would be interesting in seeing how they performed over the same period.


    • Thanks Ben.

      The “average” is only half of the equation and for non-super investors (who have to pay full capital gains on stocks), the 9% average is baloney.

      It seems dividends really matter, although they are declining.

      As I said before, there is a place for index investing and it mainly resides in super due to the franking credit bonanza attached to Aussie stocks.

      The major problem is in over 130 years of Australian stock data, there is no normal distribution of annual returns – corrections are usually fierce and bubbles proliferate and provide most of the “average”.

      And a third of the time, the market goes nowhere at all – so you MUST rely on dividends.

      Agreed on small caps – its the only area where active fund managers/stock pickers can really beat the market, contrary to established theory.

      • I totally agree with your research Prince. The only thought I have is maybe if you were to take into account franking credits (which were introduced in 1987), you may see an uplift in the dividend yield, which may account for some of the fall in dividends that you noted since 1991.

        Also I agree that small caps are the only area where active fund managers/stock pickers can really beat the market. Standard & Poor’s recently released a report which showed that over the last 5 years the Index beat 81% of Australian Active managers.

    • I wouldn’t place too much ‘The money is made in small caps’ meme if I were you.

      Robert Schiller has done work on this, and his conclusion was the in regards to being in a small cap index, outide of a window between 1965 to 1985, it has pretty much tracked general top 200 indicies since 1880. It followed up saying that a unique set of conditions framing either side of the 1970’s, we can infer stagflation, promoted extraordinary gain in small caps, or imputed extraordinary cost on all business that small caps could over come that big business could not.

      I would subscribe to the latter where the burden of bureacracy and rent-seeking agents caused too much drag for big business.

      So for active managers to ‘beat the market’ via small caps isn’t due to the nature of small caps as an investment, as a study of small indexes show they do nothing, though they are more senstive to survial bias due to successful small companies dropping out and becoming big ones.

      I would suggest here beating the market has more to do with active managers picking the right stocks.

      Whether they achieve this through insider trading or exceptional foresight remains to be seen.

      • Rusty

        Schiller’s work was primarily around small cap indexes, if I remember correctly. I am arguing that it is easier to outperform the market by actively investing in small cap stocks rather than actively investing in large cap stocks. Given the mandate of most fund managers, and their size, many companies outside of the ASX300 are largely ignored, and this can and does mean great companies are overlooked.



  2. ceteris paribus

    Thank you for this analysis and its dissonnance with the overblown rhetoric of the FS industry. Great to get the facts out on the table.

    I admit to being a naive investor and I may not have even read your article correctly.

    But to me, a 6.7% return on top of inflation for an essentially passive index investment seem pretty good. Then add to that a bit of contrarian adjustment when the market is either overbought and oversold. Plus put it in super with a 15% only investment tax on accummulation and no tax on drawdown and you are talking about systematic path to financial independence. Or are my expectations way too low?

    • 3 points ceteris:

      1. its an average. If you look at the 130 years of data available, only a handful of years were indeed 6-7% real return, and almost nowhere did this happen year on year, i.e a trend. Volatility ruled: you can have a decade of plus/minus 20% annual change in price and end up with zero growth in toto.

      2. the two major advantages to super are a greatly reduced CGT (effectively 10%) and franking credits, which boost dividend yields by 20% + (i.e for every 7c in fully franked dividends, you will receive another 1.5c tax back). Both of those advantages can be taken away in a regulator stroke of the pen. Unlikely, but possible.

      3. the measure of inflation I believe is grossly understated – by as much as 100% or more. So 6.7% may become 3% very quickly. This is why deflation is almost always a good thing, even for shares!

      My asset allocation model, which I will explain soon, does take advantage of this situation but recognises that you cannot tame market volatility (at no cost that is) and you shouldn’t rely solely on the share market to provide you with above inflation returns.

      • ceteris paribus

        So I think I might see what you are saying about annual averages.

        For example, if you check the equity performance component of your super and it says that, over a 5 year period, this component has recorded an average an 9.5% annual return, that does not equate mathematically to you receiving 9.5% yearly compounding interest on your balance of 5 years ago (assuming no new ingoing contributions).

        Is that the problematic mathematical assumption in averages that you are point you are making? Different rises and falls each year off a different capital bases?

        If that is the crux of the argument, a few 5-year series of dollar outcomes with different actual yearly interest rates (but the same overall 5 year average)on an easy initial $100 base might be illustrate.

        It would also be an interesting illustration of how wide the variances from the same annual 5-year average return arerealistically likely to be.

        Thank you

      • I’m doing some modelling on exactly that Ceteris – I’m looking at what would happen when an investor, through putting his SGC into shares (or a variety of portfolios), at various starting dates (say 1931 through to 1971 or 1969 to 2001), based on some basic assumptions (i.e completely non-discretionary, the fees/slippage issues, etc).

        Because anecdotally, the default options (which is at least 30% Aussie shares, usually up to 70% growth, 30% defensive (cash/fixed interest)) across most major super funds have been well below the “average”, even before inflation.

        • ceteris paribus

          Prince, If the variations to the downside between average annual return and real returns over a 5-10 year period are significant, you have a very interesting and important mainstream media story to tell with your research.

          Tell it with lots of very simple mathematical examples to keep the basically numerate, like me, on the same tram.

          Good writing.

          • Some of the problems come from the average trying to represent a population/distrubtion of a statistic that is rather non-norma.

            ie. there is “skew” in the data, meaning that averages/medians, etc (essentially, under-qualified point values) don’t represent very well what they are trying to represent.

            Hence, one needs to have a good understanding of how the statistic is distributed before they can judge if the average (etc) is a good description/representation of the distribution, or a poor(er) one. Prince did touch on that briefly.

            The result can be that an average/point-value assertion might represent someone else’s situation quite well, but represent yours quite poorly; or it could be that it really represents no one’s very well at all.

            More descriptive statistics are needed when using point-values (such as standard deviations/variances, and standard errors)….and for lay-folk, being given a chart of the statistical distribution in question(typically a frequency histogram, box-plot or the like), with the average, median and standard deviation marked clearly on the chart, is a FAR BETTER way to judge how certain stats/metrics suit you and others.

            My 2c

  3. prince i dont agree small caps outperform the market better than large caps. as graham states two types of investors (entrepreneurial and passive) for passive index buying over long period is fine. for entrepreneurial. different story. concentration is what matters. i have run a concentrated aussie fund since 2001. WOW, WPL, BHP, ORG = 90% of portfolio. have a look how that has outperformed the broader market in last decade and then tell me that small caps do better. especially considering i am rigid value investor and was backing a truck up to all the above during lehman collapse. i think if you ask average guy on street to name best/top 20 companies in australia. most joe blows could name half of them. that says a lot. the rest of the ASX 200 is basically junk in my opinion. a concentrated large cap portfolio can beat the average return by around 2.5x.

    • Leon, we are talking about small cap active fund managers, which according to the latest S&P report, actually do out perform the Small Ords index (this index itself outperforms the ASX200).

      I wrote about this in my post on “the trouble with fund management”.

      I agree with your comments however – concentration is better than diversification, but it requires an “enterpreurial” investor to do so.

      Hence, index investing – in small sizes and purchased at the correct time and value – is really only for the passive or Amateur investor, and they should always assume less than 7% real returns as the best outcome.

      I notice that all of your picks have performed better than the index noted in the last picture too. Well done.

      • okay no worries. i will read the article you quoted. but i am still not even sure the XSO has outperformed the all ords. since 95 xso is up around 80%+. all ords up around 140%. what is your time frame here? how does survivorship bias figure etc. i reckon throw the S&P report in the bin. haha.

  4. Alex Heyworth

    Agree largely with the thrust of this article. However, I observe that conservative LIC’s such as AFI and Milton have succeeded in outperforming the index over very long periods of time, net of expenses. This should not be hard if you just ignore the real dogs, which any LIC management ought to be able to do, particularly given the long experience they tend to have. I would say the LICs are generally a better idea than pure index funds like those run by Vanguard.

  5. A really good read, it’s always nice to read something that both reminds me of things I have forgotten and adds some new information in to the mix.

    My only issue with it is that you use the term ‘relying on dividends’ you seem to be implying that returns don’t count unless they are in capital gains. I’d disagree, the only real return on an investment is the cash you get from it and dividends give an undeniable account of it.

    Obviously the businesses cashflow counts as well and some businesses don’t pay dividends but make plenty of money, but I’m sure you know what I am saying.

  6. Why guess at “slippage” and management fees? It would be a lot easier to just use the performance of the Vanguard Index Australian Shares Fund$500000/australian-shares/en/australian-shares.cfm

    That’s currently reporting a 7.20% annual return over the last ten years, net of fees but pre-tax.

    The problem is not with the arithmetic, or any fudging of the numbers. The problem is that the performance over the last thirty years may not be reflected in the next thirty, let alone the next ten.

  7. Lighter Fluid

    For some insight into the ‘smaller is better’ paradox, see here:

    The argument goes that if you divide the market up into ten chunks by market cap, then buy the smallest tenth, and re-balance once a year you will out-perform the market in the long run. As the above post points out, the smallest decile has a maximum market cap of only $2M. At decile 4 you are still looking below $60M. Unless you actually have more than $10 to invest this strategy just won’t work.

    Fortunately, you don’t need to go into the nanocaps to escape the hoards of analysts. Just about anything below $500M is considered small and tends to be under followed by analysts and institutions.

    ps. Good work Prince.

    I might add that you lot are what is wrong with our economy – since Macrobusiness started up I’ve noted a sharp decrease in (my) productivity 😉

  8. Great article Prince! Puts a shame to tens of pages of reports put out by industry to paint the rosy picture.

    First up would I be right in interpreting your 1st point of contention to cp and your suggestion of further modelling is concerned with distilling of geometric averages rather that arithemtic averages. That is as to how your portfolio would have performed on a rolling basis taking into account yearly returns specifically.

    Secondly allow me to point out that this potential out performance of small caps against the market is another fally of EMH, whereby they fail to explain as to how is this possible. Let me guess (aside from survivorship bias you alude to )…. Exponential function….Growing from a small base a company can experience large and sustained growth as compared to a large cap (disclosure: read somewhere the turnover rate in small caps index is relatively high)

  9. A great article! As a financial planner I find the biggest challenge is educating people on reality. When fund managers and stock “evangelists” can advertise the great success (of course with disclaimers of what may not be future performance), it becomes a hard slog teaching people:
    1) Markets don’t do 10%+ forever, let alone 2-3 years running (that is easier to teach now)
    2) Averages are often simplistic, eg: simple interest average returns V real compounded return.

    The best example I’ve seen took a roughly net sideways return and averaged the “periods” to show a positive return. One huge downswing, followed by a few upswings can still look ok, even if the result is still behind your starting value – people’s expectations and perceptions are always a challenge.

    I love some of the stats you have collated, and I am very keen to share your site with both colleagues and clients.