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Long term returns

What Are Long-Term Returns?

Long-term returns refer to the gain or loss on an investment over an extended period, typically five years or more. This concept is fundamental to investment performance within the broader category of financial analysis. Calculating long-term returns involves considering both capital appreciation (an increase in the asset's value) and income generated, such as dividends or interest payments. Investors often focus on long-term returns to assess the true success of a portfolio, as shorter periods can be heavily influenced by market volatility. The emphasis on long-term returns aligns with strategies like buy and hold, which suggest that time in the market can mitigate the impact of short-term fluctuations and allow for the power of compounding to take effect.

History and Origin

The concept of evaluating investment performance over the long term has been intrinsic to financial markets for centuries, as investors naturally seek to understand the profitability of their holdings over time. However, the systematic study and popularization of "long-term returns" as a distinct analytical focus gained significant traction in the 20th century with the rise of modern portfolio theory and widespread public participation in stock markets. Academic research and historical data analysis began to consistently demonstrate that, despite short-term fluctuations, certain asset classes, particularly equities, have historically delivered positive returns over extended periods.

For instance, an analysis of the S&P 500 index illustrates this pattern, showing average annual returns over long stretches, even when accounting for market downturns. The Federal Reserve Economic Data (FRED) provides extensive historical data for key market indicators, allowing for such long-term performance evaluations4. This long-term perspective is crucial for understanding how wealth accumulation occurs over generations and why patience can be a virtue in investing.

Key Takeaways

  • Long-term returns measure the total financial gain or loss of an investment over multiple years, typically five or more.
  • They provide a more accurate picture of an investment's performance than short-term metrics, which can be distorted by temporary market events.
  • Factors like compounding, reinvested dividends, and the ability to ride out periods of market volatility contribute significantly to positive long-term returns.
  • Successful long-term investing often involves establishing clear financial goals and adhering to a disciplined investment horizon.
  • While past performance does not guarantee future results, historical data generally supports the benefits of a long-term approach for wealth creation.

Formula and Calculation

The calculation of long-term returns can be expressed using different methodologies, but one common approach is the compound annual growth rate (CAGR), which provides a smoothed annual return over the investment period.

The formula for Compound Annual Growth Rate (CAGR) is:

CAGR=(EVBV)1n1CAGR = \left( \frac{EV}{BV} \right)^{\frac{1}{n}} - 1

Where:

  • (EV) = Ending Value of the investment
  • (BV) = Beginning Value of the investment
  • (n) = Number of years (investment horizon)

For example, if an investment of $10,000 (Beginning Value) grows to $25,000 (Ending Value) over 10 years ((n)), the CAGR (long-term return) would be calculated as:

CAGR=(2500010000)1101CAGR = \left( \frac{25000}{10000} \right)^{\frac{1}{10}} - 1 CAGR=(2.5)0.11CAGR = (2.5)^{0.1} - 1 CAGR1.0961CAGR \approx 1.096 - 1 CAGR0.096 or 9.6%CAGR \approx 0.096 \text{ or } 9.6\%

This indicates an average annual growth rate of approximately 9.6% over the ten-year period. It is important to note that CAGR assumes returns are reinvested and smoothed over the period, providing a good measure for long-term performance. Another important metric is total return, which includes both capital gains and income generated.

Interpreting Long-Term Returns

Interpreting long-term returns requires understanding the context in which they are achieved. A high long-term return is generally desirable, but it should always be considered in relation to the risk tolerance taken to achieve it. For instance, a return of 10% per year might be excellent if achieved with low volatility, but less impressive if it came with extreme swings. Investors often compare long-term returns against relevant benchmarks, such as market indices like the S&P 500, to gauge whether their investment performance is competitive.

It's also crucial to factor in inflation. Nominal returns show the raw percentage gain, but real returns (nominal returns adjusted for inflation) indicate the actual increase in purchasing power. A positive nominal long-term return might still result in a loss of purchasing power if inflation was higher. Understanding the real long-term return is vital for maintaining and growing wealth effectively over time.

Hypothetical Example

Consider an individual, Sarah, who invests $5,000 annually into a diversified stock portfolio for 20 years. Assume her portfolio achieves an average annual long-term return of 8%.

Year 1:

  • Initial Investment: $5,000
  • Year-end Value: $5,000 * (1 + 0.08) = $5,400

Year 2:

  • New Investment: $5,000
  • Total at start of year: $5,400 + $5,000 = $10,400
  • Year-end Value: $10,400 * (1 + 0.08) = $11,232

This process continues for 20 years. Due to the effect of compounding and consistent annual investments, Sarah's total contribution over 20 years would be $100,000 ($5,000 x 20 years). However, the final value of her portfolio, factoring in the 8% long-term return, would significantly exceed this. This hypothetical example illustrates how consistent long-term returns can lead to substantial wealth accumulation over time.

Practical Applications

Long-term returns are a cornerstone of sound financial planning and investment strategy. They are widely used in several practical applications:

  • Retirement Planning: Individuals and financial advisors project future wealth based on anticipated long-term returns of various asset classes, helping determine contribution amounts needed to reach retirement goals.
  • Endowment and Pension Fund Management: Large institutional investors, such as university endowments and pension funds, prioritize stable long-term returns to meet their perpetual or long-dated liabilities. Their asset allocation strategies are heavily influenced by the historical long-term performance of different investment categories.
  • Valuation Models: Businesses and analysts use expected long-term growth rates and returns in discounted cash flow (DCF) models to estimate the intrinsic value of companies and projects.
  • Economic Policy: Central banks and governments often consider long-term economic growth and investment returns when formulating fiscal and monetary policies, as sustained long-term returns contribute to overall economic prosperity. For instance, the U.S. Securities and Exchange Commission (SEC) provides investor bulletins emphasizing the importance of understanding the long-term implications of investment decisions, including the impact of fees over time3. Empirical studies also support that maintaining a long-term view of portfolios can lead to sustainable returns2.

Limitations and Criticisms

While focusing on long-term returns offers significant advantages, it is not without limitations or criticisms. One primary critique is that "past performance is not indicative of future results." While historical data often shows positive long-term trends for diversified investments like the S&P 500 (which has an average annual return of approximately 9.96% over the last century), there is no guarantee that these trends will continue. Unexpected geopolitical events, technological disruptions, or systemic financial crises can alter long-term trajectories.

Another limitation is that achieving strong long-term returns often requires investors to endure periods of significant downturns, such as a bear market. Investors with a low risk tolerance or those who need access to their capital sooner than anticipated may find it difficult to stick with a long-term strategy through volatile times. Additionally, the definition of "long term" itself can be subjective; what one investor considers long term (e.g., five years) another might consider medium term (e.g., ten years or more). The Australian Centre for Financial Research has published a paper detailing both the benefits and pitfalls of long-term investing, highlighting factors such as incentive structures and illiquidity that can complicate such strategies1.

Long-Term Returns vs. Short-Term Returns

The distinction between long-term returns and short-term returns lies primarily in the time frame over which the investment performance is measured. Long-term returns pertain to periods typically exceeding five years, often encompassing a decade or more. They are less susceptible to daily news cycles, transient market sentiment, or seasonal fluctuations. Long-term returns tend to reflect fundamental economic growth, corporate earnings, and the overall trajectory of an asset class. The goal of pursuing long-term returns is often wealth accumulation and meeting distant financial goals.

In contrast, short-term returns are measured over brief periods, ranging from days to a few years. These returns are highly sensitive to immediate economic data, company announcements, investor speculation, and unexpected events. Short-term returns are characteristic of trading strategies aimed at profiting from rapid price movements, and they often carry higher risk-adjusted returns volatility. While short-term gains can be significant, they are also more unpredictable and subject to rapid reversals. The confusion between these two often arises when investors attempt to project short-term market behavior onto long-term investment outcomes.

FAQs

What is considered a good long-term return?

A "good" long-term return is subjective and depends on your individual financial goals, the amount of risk tolerance you are comfortable with, and the prevailing economic conditions. Historically, diversified portfolios invested in the stock market have delivered average annual returns in the range of 7% to 10% over many decades, before adjusting for inflation.

Why are long-term returns generally smoother than short-term returns?

Long-term returns are generally smoother because they allow time for investments to recover from temporary downturns and for compounding to work its effect. Over longer periods, the impact of daily or monthly market volatility tends to even out, and fundamental economic growth drivers become more dominant.

How does compounding affect long-term returns?

Compounding is the process where the returns on an investment are reinvested, generating their own returns. This creates a snowball effect, accelerating the growth of your investment over time. The longer your investment horizon, the more powerful compounding becomes in boosting your long-term returns.

Can long-term returns be negative?

Yes, long-term returns can be negative, although historically, for broadly diversified portfolios, this is less common over very extended periods (e.g., 20+ years). Significant economic depressions, prolonged recessions, or major geopolitical events could lead to negative long-term returns, especially if investments are not properly diversified across different asset classes.