Wall Street "strategists" have already started forecasting the stock market for 2017. This Yahoo Finance article quotes strategists at some of the largest investment firms, with most giving their estimated ending value for the S&P 500 index. I took these estimates, adjusted for expected dividends, to calculate the estimated total returns. The average return came out to 7 percent.
The striking part is that the range was only from 1.8 to 10.9 percent, which is quite narrow. But don't interpret this to mean stocks will return 1.8 to 10.9 percent next year.
Though I wish investing in stocks had only a downside of earning a positive 1.8 percent, it isn't so. We only need to go back to 2008, when the total return of the S&P 500, including dividends, was a decline of 37 percent, according to the investment research company Morningstar.
The experts at Morningstar predict that the average annual performance for stocks will be 4 percent over the long run, plus inflation. If inflation hits the 2 percent target of the Federal Reserve, that translates to a return of about 6 percent next year. That's not far off the 7 percent average of the Wall Street strategists in the Yahoo Finance article.
AARP Discounts: Discover great deals and savings as an AARP member
But just how risky will the market be to get that return? I did some calculations from past stock market volatility going back to 1926. With some simple statistical tools, I'm able to forecast the following for 2017:
I'm 95 percent certain the stock market will return between -36 percent and +48 percent.
What this means to you
Clearly my prediction is not nearly as satisfying as the numbers offered by the Wall Street strategists, but I think it's a whole lot more useful. The implications of my forecast are as follows:
- First, understand what a 36 percent or greater decline in stocks would do to your portfolio and ask yourself how you would behave if such a decline happened. I can only tell you that buying more stocks after the 2008 market plunge was the hardest thing I've ever done in investing.
- Second, look back to your brokerage statements in late 2008 and early 2009 to see how you behaved. I think what you did in past stock plunges is the best predictor of what you will do in the next plunge.
- Third, imagine that the 36 percent plunge does occur and what impact it would have on your retirement plans. Write down what you wish you had done, assuming you had a time machine enabling you to make a more rational decision.
- Finally, weigh the volatile 6 or 7 percent expected return against a very safe 2 percent return through five-year CDs, backed by the FDIC.
Embrace the fact that the stock market is always far riskier than the experts imply. Set your overall allocation between stocks and high-quality bonds and CDs accordingly.
Allan Roth is the founder of Wealth Logic, an hourly based financial planning firm in Colorado Springs, Colo. He has taught investing and finance at universities and written for Money magazine, the Wall Street Journal and others. His contributions aren't meant to convey specific investment advice.