Weekly outlook

Feast and famine – do good years always follow bad?

By Tom Stevenson, 15 April 2009

Analysing stock market returns over the past century and more shows how extreme the market fall in 2008 really was

If you were to measure the height of everyone who lives in your town and then plotted the results on a chart, it would look something like the picture below. A lot of values would cluster around the average height with progressively fewer people showing up as either much taller or much shorter than average. Statisticians call this a “bell-curve” distribution because, rather obviously, it looks a bit like a bell. The example below shows not heights but the annual returns for the UK stock market for every year since 1900. The data has been collected by a group of academics at the London Business School and is published each year in the Credit Suisse Investment Returns Yearbook.

“Unless the investment world has changed completely, the odds are still in investors’ favour” Tom Stevenson

The chart shows that, as with heights, the returns from investing in shares tend to cluster around an average. The ranges either side of this account for the next largest number of years and so on until at either side of the chart just a single year appears in the ranges showing the biggest gains or falls.

A number of observations can be made about this chart:

The first is that there are more positive years than negative ones. This reflects the fact that the economy has tended to grow over the past hundred years. The stock market, as a measure of this economic growth, has therefore risen in 79 of the 109 years in the sample and the greatest number of returns lies between plus 10% and plus 20% a year (including dividends and adjusting for inflation).

The second point, which slightly undercuts the first (but only a bit), is that this positive “skew” to the chart is also a statistical quirk reflecting the fact that if you lose 25% of your money one year you need to increase it by 33% the next year just to get back to where you started. Even if the stock market had moved sideways over the period, the bell curve would be centred to the right of zero.

The third observation is that very bad years can be followed by very good ones. Take 1931, for example, which fell in the minus 20% to minus 30% band and was followed in 1932 by a rise of between 30% and 40%. The worst year of all, 1974, was followed by the very best year of all. For this reason, it is tempting to think that 2008, the second worst year in the period, could be followed by a better outcome in 2009.

But don’t get carried away! Big falls are not always followed immediately by big rises. In 1914, 1930, 1973 and 2000, declines preceded another year of falling prices. In 2000, the market went on to fall for a third year in succession. Observation number four is that a negative year is no guarantee of a positive outcome the following year.

The final point to take away from this chart, however, is the fact that in nine years out of ten returns from the UK stock market have fallen between minus 20% and plus 40%. In other words, what happened in 2008, like the dreadful fall of 1974, was – thank goodness - an extremely unusual event.