Historical returns: Meaning, Criticisms & Real-World Uses

What Are Historical Returns?

Historical returns represent the financial gains or losses an investment, portfolio, or market index has experienced over a specific past period. These returns are a fundamental component of investment analysis and provide a factual record of past performance, serving as a basis for understanding how different assets have behaved under various market conditions. By examining historical returns, investors can analyze trends, measure the effectiveness of investment strategies, and gain insights into the relationship between risk-adjusted return and reward. The concept of historical returns is crucial for evaluating the actual return on investment, encompassing both capital gains and income components like dividend yield.

History and Origin

The practice of tracking and analyzing historical returns evolved alongside the development of organized financial markets. While informal records of investment outcomes likely existed much earlier, the systematic collection and analysis of historical returns gained prominence with the growth of modern stock exchanges and the increasing sophistication of financial instruments. Major market indices, such as the S&P 500, began providing comprehensive historical data that became foundational for financial research. For instance, the S&P 500 index's historical annual returns data extends back to 1927, evolving from the S&P 90 to its current 500 components by 1957, offering a rich dataset for long-term performance analysis.¹³,¹² This extensive historical record allows for the examination of market behavior across various economic cycles and significant global events.

Key Takeaways

Historical returns quantify past investment performance, providing a factual record of gains or losses.
They are a critical input for financial modeling, portfolio management, and setting realistic future expectations.
Historical returns include both price appreciation and income generated (e.g., dividends or interest).
While informative, past performance of historical returns does not guarantee future results due to changing market dynamics and economic conditions.
Analyzing historical returns across various time horizons helps in understanding an investment's long-term behavior and its sensitivity to different market cycles.

Formula and Calculation

Historical returns can be calculated in various ways, depending on the time horizon and whether compounding is considered.

1. Simple (Arithmetic) Annual Return:
This is the simplest form and represents the percentage change over a single period.

\text{Simple Return} = \frac{\text{Ending Value} - \text{Beginning Value} + \text{Income}}{\text{Beginning Value}}

Where:

Ending Value = The value of the investment at the end of the period.
Beginning Value = The initial value of the investment.
Income = Any dividends, interest, or other cash distributions received during the period.

2. Compound Annual Growth Rate (CAGR):
CAGR provides a smoothed annualized return over multiple periods, accounting for the effect of compounding.

\text{CAGR} = \left( \frac{\text{Ending Value}}{\text{Beginning Value}} \right)^{\frac{1}{\text{Number of Years}}} - 1

Where:

Ending Value = The value of the investment at the end of the entire period.
Beginning Value = The initial value of the investment.
Number of Years = The total number of years in the investment period.

Interpreting the Historical Returns

Interpreting historical returns involves more than just looking at a single number. It requires understanding the context, time horizon, and considering various influencing factors. For instance, a nominal historical return does not account for inflation, which erodes purchasing power. A real return, adjusted for inflation, provides a more accurate picture of an investment's growth.

When evaluating historical returns, it is important to consider the period over which they were generated. Shorter periods can be heavily influenced by temporary market fluctuations, leading to skewed perceptions of performance. Longer-term historical returns, spanning decades, tend to smooth out short-term volatility and provide a more representative view of an asset's typical behavior. Additionally, comparing an investment's historical returns to a relevant benchmark index helps assess whether it outperformed or underperformed its peers or the broader market.

Hypothetical Example

Suppose an investor purchased shares of a company for $1,000 five years ago. Over these five years, the investment distributed $50 in dividends and is now worth $1,400.

To calculate the simple total historical return:

\text{Simple Total Return} = \frac{(\$1,400 - \$1,000) + \$50}{\$1,000} = \frac{\$400 + \$50}{\$1,000} = \frac{\$450}{\$1,000} = 0.45 \text{ or } 45\%

To calculate the Compound Annual Growth Rate (CAGR) for this portfolio management scenario (assuming dividends were reinvested and contributed to the ending value of $1,400):

\text{CAGR} = \left( \frac{\$1,400}{\$1,000} \right)^{\frac{1}{5}} - 1 = (1.4)^{\frac{1}{5}} - 1 \approx 1.0696 - 1 = 0.0696 \text{ or } 6.96\%

This indicates that, on average, the investment grew by approximately 6.96% per year over the five-year period, representing a reasonable performance in an asset allocation strategy.

Practical Applications

Historical returns are widely used in various facets of finance and investing:

Investment Analysis: They form the basis for evaluating mutual funds, exchange-traded funds (ETFs), and individual stocks. Investors often examine past performance to understand how a particular investment has performed relative to its peers or a benchmark index.
Financial Planning: Planners use historical market data to project potential future outcomes for retirement planning, college savings, and other long-term financial goals. While not a guarantee, long-term historical averages of broad market indices, like the S&P 500, can inform reasonable growth assumptions.¹¹
Risk Assessment: Analyzing the historical volatility of returns helps investors understand the level of risk associated with an asset. Assets with higher fluctuations in historical returns are generally considered riskier.
Backtesting Strategies: Investment professionals use historical returns to backtest and refine trading strategies, assessing how a particular strategy would have performed under past market conditions.
Economic Research: Economists and financial academics use long-term historical return data to study market efficiency, the impact of monetary policy, and economic cycles. For example, the Federal Reserve's historical data on the federal funds rate provides insight into how changes in interest rates have historically influenced financial markets and investment returns.¹⁰,⁹

Limitations and Criticisms

While historical returns offer valuable insights, they come with significant limitations. The primary criticism is that "past performance is no guarantee of future results." Market conditions, economic landscapes, and geopolitical environments constantly evolve, meaning that what happened historically may not repeat itself.⁸,⁷

Key limitations include:

Non-Stationarity: Financial markets are dynamic, and patterns observed in the past may not persist. Economic and political events, technological advancements, and regulatory changes can fundamentally alter market behavior. For instance, the impact of major events like the 2008 Global Financial Crisis demonstrably affected stock market efficiency and predictability, showing that market dynamics can shift significantly.⁶,⁵
Survival Bias: Historical data often only includes companies or funds that have survived, leading to an overestimation of average returns by excluding those that failed or were delisted.
Data Mining Bias: Researchers might inadvertently or intentionally search for patterns in historical data that appear predictive but are merely coincidental, leading to strategies that fail in live markets.
Black Swan Events: Unforeseen and impactful events, known as "black swans," are not reflected in typical historical distributions and can severely disrupt established patterns of returns. The Efficient Market Hypothesis suggests that all available information is already priced into assets, making consistent outperformance based on historical data difficult.
Inflation Impact: Unless adjusted for inflation, nominal historical returns can overstate real purchasing power gains.

Therefore, while historical data is crucial for understanding general market tendencies and risk, it should be used with caution and complemented by forward-looking analysis and a robust diversification strategy.

Historical Returns vs. Expected Returns

Historical returns are backward-looking; they are a factual record of how an investment has performed over a specific past period. They tell you what did happen. For example, knowing the S&P 500 had an average annual return of approximately 10% historically provides insight into its past growth.⁴,

In contrast, expected returns are forward-looking estimates of what an investment is projected to earn over a future period. These projections are based on a combination of historical data, current market conditions, economic forecasts, valuation models, and qualitative factors. While historical returns often serve as a starting point for forming expectations, expected returns explicitly acknowledge that future performance may deviate significantly from the past. The confusion arises because investors often implicitly or explicitly use historical averages as their expectation for the future, despite the well-known limitations of doing so.

FAQs

Q1: Are historical returns reliable indicators of future performance?
A1: While historical returns provide valuable context and insight into how assets have behaved, they are not reliable predictors of future performance. Market conditions are constantly changing, and past results do not guarantee future outcomes.³

Q2: How do historical returns account for market downturns like a recession?
A2: Historical returns capture all periods, including market downturns and recoveries. Analyzing historical returns over long periods helps to see how investments have performed through various economic cycles, illustrating their resilience or vulnerability during periods of stress.

Q3: What is the difference between nominal and real historical returns?
A3: Nominal historical returns are the raw percentage gains or losses before accounting for inflation. Real historical returns adjust for inflation, providing a more accurate measure of the increase or decrease in purchasing power of an investment.

Q4: Can historical returns help with asset allocation decisions?
A4: Yes, historical returns are often used in asset allocation to understand the past risk and return characteristics of different asset classes (e.g., stocks, bonds, real estate). This helps investors design portfolios that align with their risk tolerance and financial goals, considering the historical correlations between assets.

Q5: Where can I find reliable historical return data?
A5: Reliable historical return data for major market indices, such as the S&P 500, can be found from reputable financial data providers, academic institutions, and central banks like the Federal Reserve, which publishes historical interest rates.²,¹