3 Investment Factors that Don’t Drive Long-term Returns
As a long-term investor, you’re always thinking about what factors drive your investment returns. Unfortunately, many investors focus on things that cause short-term changes and actually have no impact on long-term market returns. It’s not their fault – these myths are so commonly believed that many so-called “savvy investors” would preach to you of their importance.
To help you make informed investment decisions, let’s look at three investment factors that, contrary to popular belief, don’t drive long-term investment returns.
1. Earnings reports
Four times a year investors wait on pins and needles for their favorite companies to release earnings reports. While these reports give an update on how the company is performing and challenges it may be facing, they aren’t a good barometer of long-term investment returns, and investors greatly overvalue earnings reports when considering a potential investment.
If earnings were an indicator of investment returns, we would expect to see earnings growth precede a rise in investment returns, but this isn’t the case. Looking at the S&P Composite Index, we can see that earnings and returns do not align as expected. In fact, over the past century there’s been almost no correlation between earnings growth and investment returns.
Takeaway: Earnings should be taken with a grain of salt. Don’t let these quarterly calls influence your long-term investing goals.
2. Geopolitical crises
Regional tensions in Russia, the Middle East, and China, are causing investors fear over another world war. You might think these fears are reason to be hesitant about your investments, but history shows that while these occurrences might cause temporary volatility, the market is very resilient to even the most negative geopolitical events.
In the short-term, the market tends to drop 1% following a geopolitical crisis event, with the total average drawdown being only 4.7% to the negative. When looking at the long-term effects of such events, the picture is even brighter. The average market return in the 12-month period following a major geopolitical crisis was +2.1%, displaying just how resilient markets are, and how these events only had a short-term impact on returns.
Takeaway: A geopolitical crisis can cause minor, short-term declines, but have no effect on the long-term market outlook.
3. Periods of extremely high or low valuations
When looking at price-to-earnings (P/E) multiples over time, it seems that stocks can go through periods of extremely high (and low) valuations, but they are never sustained. As seen in the chart below, the 25-year average P/E ratio for the S&P 500 is 16.4, and even though the market has fluctuated above and below this average, valuations always revert back toward this average.
In fact, it’s generally only in very specific economic conditions (like near-zero interest rates, the 2008 Financial Crisis, or the COVID pandemic) that valuations deviate from their historical average for any considerable period of time.
Takeaway: Extremely high or low valuations aren’t sustainable, and markets almost always revert back to their historical averages.
Making smarter, more informed investment decisions
If factors like earnings reports and geopolitical events don’t influence stock returns, then what does? For long-term investors, fundamentals are still the bread and butter of valuing stocks. This includes earnings growth, dividends, and cash flows.
The market will always fluctuate based on recent events and news, and while that might scare some investors, you can stop worrying about fleeting moments, and get back to focusing on the fundamentals of investing to make more informed investment decisions.
Sources
1. Chart #1 Source: https://blogs.cfainstitute.org/investor/2021/03/22/myth-busting-earnings-dont-matter-much-for-stock-returns/
2. Chart #2 Source: https://www.lpl.com/research/blog/middle-east-conflict-how-stocks-react-to-geopolitical-shock.html
3. Chart #3 Source: https://insight.factset.com/sp-500-forward-p/e-ratio-rises-above-20.0-for-first-time-in-2-years
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