The Fickleness of Five-Year Returns

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When you compare returns, most funds report the latest 1-year, 3-year, 5-year, and 10-year returns through the end of the last month. The major problem with this approach is the specific start and end dates influence the return of each time frame. By rolling those time periods forward or backward one month or sometimes even one day, the figures can change significantly.

I remember the end of March 2014 as having wonderful 5-year returns. Most portfolios were up over 13% annualized even though, just six months earlier, the 5-year returns were less than half of that. What changed had little to do with returns from October 2013 through March 2014. Instead, it had everything to do with what was happening 5 years earlier in October 2008 to March 2009 (The Financial Crash).

While the difference between a five-year-old and a newborn is stark, in investment management theory, five years is a fairly short time period for measuring performance. While stocks generally trend upward, one standard deviation of five-year stock returns still includes negative returns.

Currently, the five-year return ending September 30, 2023 looks bad. However, the returns are likely to become remarkably better in one quarter. This is not because of what will happen in the next three months, although folk wisdom would suggest that a September sell-off might be followed by an October bounce . Rather this is because the quarter five year ago will roll off the 5-year returns. That was the quarter from October 2018 through December 2018, the Almost Bear Market of 2018.

Recent rolling time periods have had several volatile quarters. In the past 5 years, we have experienced the Almost Bear Market of 2018, the 2020 COVID Bear Market, and the Bear Market of 2022. Additionally, the past two months have been down, with September 2023 down almost 5%, the worst month of this year .

Whenever a downturn of -20% rolls off a 5-year return, the new 5-year return should look 4.56% better. This is due to how annualized returns are calculated. The math here is (100/80)^(1/5)-1 or 4.56%.

The quarter that is rolling off isn’t quite a Bear Market, and the almost Bear Market was an inter-month event. Regardless, returns should look much better next quarter even if the market is flat.

This phenomenon, where return reporting can create either darker or rosier pictures, is one reason why the most common past performance disclaimer is perhaps too weak. It could be strengthened to: “Past performance has little if anything to do with future returns.” Even five years isn’t long enough to judge an investment strategy.

For those who are curious, here is a review of the five-year price movements in the S&P 500:

Five-Year Price Movements in the S&P 500 (Feb 1928 – Sept 2023)

On average, the stock market moves up 44.37% every five years. But five years is not long enough to ensure a positive return within one standard deviation. On average 20.39% of rolling five-year returns are negative. While unfortunate, being invested during a down 5-year period is not a mistake. Such five-year periods are simply a normal part of market volatility.

We have had lost demi-decades ending in 1933, 1934, 1935, 1938, 1940, 1941, 1942, 1943, 1944, 1970, 1973, 1974, 1975, 1977, 1978, 2002, 2003, 2004, 2005, 2006, 2008, 2009, 2010, 2011, and 2012. And the worst rolling 5-year period for the S&P 500 was a cumulative loss of -71.14% ending in August 1934.

Such five-year periods obviously can happen. And at the end of such a five-year period, what do you want your advisor to do? You don’t want your advisor to panic and sell everything. You want them to remain calm and rebalance your portfolio, selling some bonds and buying more stocks.

The rebounds are often steep. For example, the worst 5-year trading period in 2003 was down -23.02 at the end of March 2003, but the subsequent 5-year period was up 51.11%. And the worst 5-year period in 2009 was down -35.80% at the end of February, 2009, but the subsequent 5-year period was up 152.95%.

The markets are inherently volatile, but they can also wildly go up.

The best rolling 5-year period ended May 1937 with the markets up 263.76%. The best rolling 5-year period in recent times ended Dec 1999 with the markets up 219.91%.

Photo by Joshua Sortino on Unsplash. Image has been cropped.

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President, CFP®, AIF®, AAMS®

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.