Yes. The age old question of ‘expected’ returns comes back with a vengeance.
The question of expected rate of return is one of significance. It affects many aspects of portfolio management. For instance, institutions such as pension funds have an assumed rate of return needed to determine funding levels. Insurance companies must project their assets and liabilities many years into the future. The difference of an expected annual return of 10% and 9.5% makes an enormous influence on a multi-billion portfolio.
If you’ve ever spoken with an investment advisor, portfolio consultant, financial planner or other investment salesperson, you were likely given what I call the “10% dogma.” As in: “the stock market typically goes up 10% per year.” You may have even been shown nice charts and graphs showing this to be true – a steady upward march of equities over the past 80 years.
The 10% dogma has become so ingrained that it’s hard to have a serious conversation with someone about equity returns while discussing anything in the single digits. In my view it’s become an insidious problem negatively affecting individuals and institutions alike.
As you might already surmise I do not take the position that one can EXPECT double digit returns over time from a diversified public equity portfolio.
There are several problems with the 10% dogma, which I will try to address in an effort to show what I think is a reasonable expected rate of return.
The first – and biggest – issue with using the 10% dogma is how it is used. Context is very important. You typically are told “the average annual rate of return for the equity market is 10% (or so) per year.” The key word here is “average.”
For example, let’s say you held a portfolio starting with $100 that went up 50% in year 1, down 25% in year 2 and up 20% in year 3.
Your average annual return would be 15% (50-25+20/3).
But what you really want to know is what your compound annual rate of return is. “Volatile” investments, like stocks, are typically quoted given the simple average rather than the return you actually get.
The compound annual rate of return (or compound annual growth rate – CAGR) from our example above is: 10.52%
Wow! We went from 15% to 10.52%. That’s a pretty big difference. Imagine that difference in a multi-billion portfolio modeling exercise.
(surely no wise investment professional would ever make that mistake!)
The next problem with using the 10% dogma is that it does not take into account when the portfolio was set up.
For example, let’s say I was 30 years old in 1960. My investment time horizon was 30 years (I wanted to retire at age 60). I put $10,000 into the S_P 500. In 1990 I would have roughly $180,000. My “average” annual rate of return would have been 11.04% over that time frame. Right on the dogma money, right? Well, if we use the compound annual growth rate instead, my return would have been 9.83%. Still not too far off the dogma money.
So where’s the rub?
By far the biggest and most lethal thieves come in the middle of the night to steal your wealth. And those are the triplets of: fees, taxes and inflation.
Of course, the broad investment research producing world will typically state their numbers as “before fees, inflation and taxes.” The graphs keep marching nicely upward in this context. I find it strange three biggest destroyers of investor wealth are somehow excluded from the calculation.
Inflation, a huge wealth destroyer, must be calculated into your expected returns. Why? Because you want to know how much purchasing power you will get in the future in lieu of foregoing consumption today. If you have $100 in your pocket today, you could buy $100 worth of goods and services. If inflation merely goes up at 3% per year (per the long term stated US government data), in 10 years your purchasing power has eroded by nearly 26%.
So, let’s take a look at our example of retiring in 1990 starting in 1960 when we take inflation into account.
With no inflation: CAGR = 9.83%
With inflation: CAGR = 4.59%
Now instead of having $180,000 in purchasing power in 1990, I actually have $40,000 in relative purchasing power. Inflation is a killer. You should ignore the aspect of stock market returns which are simply generated by increases in the money supply and declining real purchasing power.
(and people wonder why it is hard to retire)
Wait a second…”Adam, you’re using biased data because you are including the 1970′s in your time series which was an extraordinary inflationary event.”
Ok. Let’s say you started in 1980 with $10,000 and you wanted to retire in 2010.
With no inflation: CAGR = 11.39
With inflation: CAGR = 7.68%
Better than 4.59% but certainly still a lot less than the dogmatic figure.
In fact, if we look at a very long history of the S_P 500, the inflation adjusted CAGR is 6.72%.
Maybe it’s fair to leave taxes out for analytical purposes in our case here. But individuals should never leave this part of the equation off the table.
Fees are another killer. Let’s say the average investor (institutional or individual) pays roughly 1% per year of their portfolio in fees. Just do simple math and whack 1% off the CAGR in each case. Perhaps fees are not avoidable in many instances, but it MUST be taken into account when deriving expected returns.
What is a fair expected rate of return? Can we use the history of the S_P 500 since 1871 using a proper metric like inflation adjusted CAGR?
I think that is actually a pretty good starting point…but not for the reasons of using historical stock market time series data.
In my view, it’s better to use some simple economic figures and company performance.
If real GDP in the United States grows by a compound average of 3.5% or so per year (maybe it will be lower going forward) and corporate dividends yield in the ballpark of 2.5% or so per year, I think 6%-6.5% is a pretty reasonable expected return on a broad equity portfolio.
Wait…is it really as simple as that?
Maybe not. But I do feel it is a good starting point. It’s pretty difficult to say you will get returns above and beyond what the general economy will do and what corporate profits will do (those paid to shareholders) over a long period of time with a diversified equity portfolio.
This does not mean the total institutional or individual portfolio cannot exceed this figure. Alternative investments (private equity, venture capital, investment partnerships) and sheer luck could swing the returns higher. But often risk (as measured by likely permanent loss of principal) is increased in attempt to gain a few percentage points.
The happiness equation goes like this:
Happiness = Results/Expectations.
In a simplified way: if you want to increase your happiness, simply increase the results while keeping expectations constant. Or you can decrease expectations while keep results constant. Or somewhere in between.
Set your expected equity returns accordingly.
Tags: Expected Returns