When Equity Markets Will Get Back to "Normal"? Never

(MoneyWatch)  In light of the large losses you may have experienced in 2008, you may be asking when we'll get back to "normal" or "average" returns in the equity markets. While we cannot know how the market will perform in the short term or the long term, we can say there never was nor will be a "normal" year.

Investors allocate part of their portfolio to equities in the hope -- not the certainty -- of earning the equity risk premium. That premium is the difference between the annual average return on the stock market and the annual average risk-free rate. (The risk-free benchmark is the one-month Treasury bill.)

From 1926-2008, the annual average return of the S&P 500 Index and one-month Treasuries was 11.7 percent and 3.8 percent, respectively. The difference, or equity premium, was 7.9 percent. In other words, the market paid investors an average 7.9 percent premium for accepting the greater risk of equities.

In 2008, investors saw the risk of equities "show up" in a big way, as the S&P 500 Index fell 39 percent. This was the second-worst performance since 1926, and there were only two other years during the period when the S&P 500 lost more than 35 percent -- 1931 and 1937.

But as you can see in the table below, it's quite rare for the market to provide its average 11.7 percent return.

S&P 500 Index: 1926-2008

Total Return Range	Number of Occurrences	Percentage of Years
9% to 14%	6	7%
7% to 16%	9	11%
5% to 18%	18	22%

The data clearly demonstrates there really isn't a "normal" return. However, that's not really bad news. The wide dispersion of returns is the reason for the very large premiums we've enjoyed. If we'd had lower volatility, you'd probably view stocks as less risky. Greater demand would bid up equity prices, thus reducing their expected return.

The lesson is that you shouldn't expect average returns to occur with any regularity. In fact, you need to recognize that stocks are risky no matter how long the investment horizon. While the S&P 500 has produced positive returns in 59 of 83 years and produced an ERP of almost 8 percent, that's no guarantee of future performance.

Risk is the "price" we pay for the equity premium. A high premium is sign of high risk, and that means there will likely be a wide dispersion of future returns. In other words, if you're looking for "normal" returns, you're looking in the wrong place.