## Stock Market Returns and Risk: Returns from Various Years until 2013

This is a memo I wrote for the directors of Bloomington’s Lighthouse Christian Academy to aid them in thinking about whether it was worth putting capital account funds into the stock market, which has higher returns but also might result in a loss. It is useful for anyone wanting to know the average return on the stock market.

June 19, 2013
What investment is prudent for LCA?

Suppose LCA had \$100,000 in a given year and had invested it in the S+P 500, 500 very big companies’ stock, until May 2013. What would have become of it? What would be its annual return?

S+P returns (dividends reinvested) from the given year until 2013, annualized and total, May to May:

1963: 9.7%
1973: 10.3
1983: 10.6
1993: 8.7

2003 7.7%, 110%.
2004 6.4%, 74.5%
2005 6.2, 61.5
2006 5.4, 44.9
2007 3.3, 21.5
2008 5.1, 28.4
2009 18.0, 93.9
2010: 15.0, 52.2
2011: 12.0, 25.5
2012: 22.7, 22.7

But here are the worst post-1998 return periods I’ve found (the worst since the 1970’s, maybe the worst since the 1930’s):

2000-2009: -3.2, -25.3
2007-2008: -33.8, -33.8.

Thus, \$100,000 invested in the 500 biggest companies’ stock in 2003 would have earned an extra \$110,000 by 2013. If it had been put in the bank and earned 1% annually, it would have earned perhaps \$15,000 (more than \$10,000, because it would have earned interest on the previous years’ interest as well as on the principal).

If the \$100,000 had been invested in stocks in 2007, when the stock market collapsed, it would have earned \$21,500 by 2013. If it had been put in the bank at 1%, it would have earned about \$8,000.

Note, however, that in both of those cases, the investment had to pass through the bad year of 2007-2008 where it lost 33.8% of its value. Also, if you had invested the money in 2000, just before the crash that year, and left it in until 2009, when the market started to recover from the 2007-08 crash, you would have lost \$25,300 over those 9 years.

So, what is the prudent investment? Ex post, at least, keeping the money in the bank from 2003-2013 was extremely imprudent compared to putting it in the stock market, even though it was very safe.

I don’t know what the attitude of donors would be. I expect that small donors wouldn’t really have much of an opinion on the matter. Some big donors would be financially sophisticated, and they would probably think the stock market a good investment. They might think they’d better hold onto their money till LCA is ready to spend it, because LCA has been such a lousy steward of it. Others would not, and I don’t know what they’d think. Quite possibly, they wouldn’t mind losing \$95,000 in gains forfeited by overcaution but they would mind losing \$25,000 due to risky investments. That would then have to be taken into consideration.

Matthew 25: 14-30: For the kingdom of heaven is like a man traveling to a far country, who called his own servants and delivered his goods to them. And to one he gave five talents, to another two, and to another one, to each according to his own ability; and immediately he went on a journey. Then he who had received the five talents went and traded with them, and made another five talents. And likewise he who had received two gained two more also. But he who had received one went and dug in the ground, and hid his lord’s money. After a long time the lord of those servants came and settled accounts with them.

So he who had received five talents came and brought five other talents, saying, ‘Lord, you delivered to me five talents; look, I have gained five more talents besides them.’ His lord said to him, ‘Well done, good and faithful servant; you were faithful over a few things, I will make you ruler over many things. Enter into the joy of your lord.’ He also who had received two talents came and said, ‘Lord, you delivered to me two talents; look, I have gained two more talents besides them.’ His lord said to him, ‘Well done, good and faithful servant; you have been faithful over a few things, I will make you ruler over many things. Enter into the joy of your lord.’

Then he who had received the one talent came and said, ‘Lord, I knew you to be a hard man, reaping where you have not sown, and gathering where you have not scattered seed. And I was afraid, and went and hid your talent in the ground. Look, there you have what is yours.’

But his lord answered and said to him, ‘You wicked and lazy servant, you knew that I reap where I have not sown, and gather where I have not scattered seed. So you ought to have deposited my money with the bankers, and at my coming I would have received back my own with interest. 28 Therefore take the talent from him, and give it to him who has ten talents.

‘For to everyone who has, more will be given, and he will have abundance; but from him who does not have, even what he has will be taken away. And cast the unprofitable servant into the outer darkness. There will be weeping and gnashing of teeth.’

I use the Parable of the Talents in my econ classes to illustrate the basic economic concept of “opportunity cost”.

A good paper I came across at a conference recently is: “The Prudent Investor Rule: A Theoretical and Empirical Reassessment,” Max M. Schanzenbach* Robert H. Sitkoff. It isn’t too relevant to this discussion, but it does note that the modern “Prudent Investor Rule” says that the trustee should choose investments balancing risk and return, and choosing investments with reasonably low management fees and enough diversification to avoid unnecessary risk (which means investing in something like a mutual fund that holds 500 companies’ stocks instead of just holding 3 company’s stocks). The old, obsolete, “Prudent Man Rule” said that a trustee was safe if he just invested in certain categories of assets such as railroad bonds that had a legal presumption of safety, even if they weren’t really safe and even if a little risk would have given much higher return.