3 Investment Factors that Don’t Drive Long-term Returns
“It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so.”
― Mark Twain
If you're like me, you probably find yourself wondering, "What really drives investment returns?" Maybe that's not something you often think about—fair enough!
But as Mark Twain's quote suggests, recognizing what you think is true but isn’t can be just as crucial as finding the right answers.
Here are some events that we seasoned veterans have learned don't have as much impact on long-term investment returns as the media attention they receive might suggest.
1. Earnings reports
Every quarter, investors eagerly await earnings reports from their favorite companies. While these updates provide insight into a company’s performance and challenges, they’re not reliable indicators of long-term investment returns. In fact, investors often place too much weight on these reports when making investment decisions.
If earnings truly predicted returns, we would expect earnings growth to lead to higher investment returns. But that’s not what we see. Looking at the S&P Composite Index over the past century, there’s been little to no correlation between earnings growth and actual 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
Rising tensions in Russia, the Middle East, and China have some investors worrying about the possibility of another world war. It’s natural to feel cautious, but history shows that while such events may lead to short-term volatility, the market is remarkably resilient, even in the face of severe geopolitical crises.
In the immediate aftermath of these crises, the market typically drops by just 1%, with the average total drawdown reaching only 4.7%. But the long-term picture is much more optimistic. On average, the market gains 2.1% in the 12 months following a major geopolitical event, highlighting its ability to bounce back from short-term disruptions.
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 examining price-to-earnings (P/E) multiples over time, it's clear that stocks can experience periods of both extreme highs and lows in valuation, but these levels are rarely sustained. As shown in the chart below, the 25-year average P/E ratio for the S&P 500 is 16.4. While the market fluctuates above and below this benchmark, valuations consistently revert toward the average.
Notably, it’s only under very specific economic conditions—like near-zero interest rates, the 2008 Financial Crisis, or the COVID pandemic—that we see significant deviations from this historical norm for extended periods.
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 earnings reports and geopolitical events don’t drive stock returns, what does? For long-term investors, the fundamentals remain the foundation of stock valuation—things like earnings growth, dividends, and cash flows.
The market will always react to news and recent events, which can rattle some investors. But instead of getting caught up in short-term noise, focus on the fundamentals. This will help you make more informed investment decisions and stay grounded amid market fluctuations
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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