No one can predict the future, but when making projections for things like retirement planning, what investment return should you expect?
What do we mean by “investment return?”
Before we get into the numbers, we need to go through a few definitions.
Nominal returns vs. real returns
These are just fancy words for before-inflation and after-inflation returns. Real returns (after-inflation) returns are equal to the nominal returns (before-inflation) minus the inflation rate. Real returns is a better metric than nominal returns in retirement planning. If you use nominal returns, then you have to adjust your projected spending in retirement by the inflation rate.
The importance of dividend reinvestment
When using historical data to estimate past investment returns, it’s easy to fall into the trap of calculating returns by just dividing the final price by the original price. For example, the S&P 500 traded at 2733 in June 2018, while it traded at 100 in June 1968. You might naively assume that someone who invested in the S&P 500 in 1968 made a 2633% return on their money over 50 years.
However, $100 invested in June 1968 would not be worth just $2733 in June 2018. It would be worth far more, because the companies in the S&P 500 have been paying dividends for the past 50 years, which don’t get accounted for in the current price. Remember that when a dividend is paid, the stock price falls by the amount of the dividend.
To maximize your investment return and take full advantage of compound interest, you should reinvest your dividends into the stock, either automatically or manually.
According to return data from DQYDJ, $100 invested in June 1968 with dividends reinvested would be worth $11,692 in June 2018, well more than $2,733 estimated from price appreciation alone.
Dave Ramsey and the 12% expected return
Dave Ramsey has one of the most optimistic projections for future returns. He has been stating for years that investors should expect a 12% return on their stock investments. It’s part of Dave Ramsey’s Financial Peace University course that has been taken by millions of people.
Dave argues that his 12% projection of future investment returns is based on historical data. Using data from 1923 to 2016, he states that the “average” annual return is 12.25%.
However, the “average” annual return simply averages the annual returns (i.e. if the stock market went up 10% in 2015, fell 10% in 2016, and rose 15% in 2017, then the average annual return would be calculated as (+10%-10%+15%)/3 = 5%).
However, this calculation ignores how the sequence of investment returns affects your actual return. Using the previous example where the stock market went up 10% in 2015, fell 10% in 2016, and rose 15% in 2017, the compound annualized growth return (CAGR) would be [(1+10%)*(1-10%)*(1+15%)] ^(1/3) = 4.4%. This percentage is a more accurate calculation of return.
Using historical return data from MoneyChimp, the CAGR for the stock market from 1923-2016 is only 10.34%.
How has the S&P 500 performed the past?
So let’s look at historical stock market returns using S&P 500 data from DQYDJ. From the origination of the S&P 500 in March 1957 to June 2018, the stock market has returned 10.2% annually with dividend reinvestment (7.0% without dividend reinvestment). This is the historical nominal return for the stock market.
After accounting for inflation, the S&P 500 (with dividend reinvestment) has returned 6.3% annually with dividend reinvestment (3.2% without dividend reinvestment).
Investors have unrealistic expectations about future returns
A survey by Natixis found that the average American investor believes they need to achieve an 8.9% annual return, after inflation, in order to meet their investment goals.
Americans are slightly less optimistic about future investment returns than investors globally, which expected a 9.9% return on their investments.
Based on historical data, most investors will likely not be able to meet their investment goals if they need a 9-10% after-inflation return.
Financial advisors are more realistic about future investment returns
Natixis also surveyed financial advisors, who believed on average that the return that they could realistically achieve investors, after inflation, was 5.9%. This number is much more in line with the historical real return of investments.
It’s unclear whether investors did not take into account inflation into their return estimates. Regardless, it is promising that financial advisors, at least when responding to a survey, appearing to be using historical data to guide their estimates of the future returns they can deliver to their clients.
Vanguard’s projections of future returns are less rosy
Vanguard publishes an annual Vanguard Market and Economic Outlook. The 2018 version predicts slower investment growth in the future, with expected nominal returns of a 100% global equity portfolio to be just 5.2%. That means future real returns could be 3% or less.
What investment returns am I using for retirement planning?
Of course, no one can predict the future. Investment returns could be really good, average, or really bad in the future. You should plan your retirement savings using conservative projections to ensure that you’ll be able to meet your retirement goals even if the market has returns lower than the historical average.
In my own retirement calculations, I use a 4% real return for my baseline scenario. To maximize the chance that I will be able to retire by age 65, I also use a more conservative projection of future returns of 2%. However, historical returns suggest that real returns, on average, are 5-7%, so I might end up with a lot of extra money in retirement, or have the opportunity to retire earlier than expected. Not a bad problem to have.
- Historical real returns with dividend reinvestment are around 5-7%.
- Dave Ramsey’s projected investment returns of 12% is likely too high.
- Most investors believe they will need higher-than-historical investment returns to meet their financial goals.
- Some investors, including Vanguard’s research team, anticipate lower than average returns in the next 10 years.
- I personally use 4% real return as a baseline projection, but also use 2% return for retirement planning.
“Wall Street Physician,” a former Wall Street derivatives trader , is a physician who blogs at his self-titled site, the Wall Street Physician.
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