What rate of return should you expect to earn on your investments?

what rate of return should you expect to earn on your investments

Early in my career, I was indoctrinated with a very powerful phrase “the stock market has averaged 12% over its history.” That phrase stuck in my head, and even made its way to my mouth very early in my career. But is it true? And if it is true, does that mean that people can expect to earn 12% per year on their investments? The answer is that 12% is a ridiculous number. But if 12% isn’t a reasonable rate of return on the money you invest, then what is? I think you will find that recent history (the last 25 years) has proven it’s much less than you think.

***Don’t be put off by all the charts and numbers in this post. This is a very easy concept to understand, and it’s very important that you understand it. If you don’t understand something that you see here, leave a comment in the comment section, and I will answer your questions.

First, I think we need some perspective. There are some things that you need to understand before my ultimate point will make any sense.

1. You need to know how/why an investment actually rises in value. When you see that your  investment account went up over any period of time, it’s because one of three things happened. Those three things are: income was paid on the investment in the form of bond interest or a stock dividend, there was a realized gain (meaning investments were sold after they appreciated in value), or there was an unrealized gain (investments that you are still holding went up in value. In most instances, your investment account goes up because the investments within the account (stocks, mutual funds, bonds, etc) went up in value. This means that the demand for these exact securities was rising during the time frame. If your account went down in value, it’s most likely because the individual securities were deemed to be less in demand (based on perceived value). In reality, the only reason that your investments are worth anything at all is because someone else is willing to buy them from you.

2. Your goal is to keep pace with “the market.” This means that your long-term investment account should keep pace with what the standard stock market indexes do, in terms of performance. BTW, when people say the market, they usually mean the S&P 500 or the Dow Jones Industrial Average. An index is selection of stocks that are used to gauge the health and performance of the overall stock market. For instance, the S&P 500 has 500 different stocks in it. If the market averages 4% over a tough 5 year period, then your investment account should do at least that well. If the market is up 24% over an awesome three year period, then your long-term investments should keep pace with this, assuming that you have at least a moderate risk tolerance. There are several reasons for this, but one of the primary reasons is cost. You may have heard in the past that you can actually invest in the indexes. This means you can buy something called an index fund, which recreates the stock portfolio of the actual index. These funds are usually dirt cheap. That means there aren’t many management fees involved. The more you pay in management fees, the less of your investment return you get to keep. Do you see where I’m going with this? If your investment account can’t keep pace with the index, and the index generally has lower management fees, then you should just own the index funds. If you are considering hiring a professional to manage your money, or even if you are just considering a standard mutual fund, make sure that there is a consistent long-term history of beating the market, net fees. The key in all of this is to beat the market without taking on unnecessary risks or fees.

3. There’s a huge difference between “averaging 12%” and “getting 12% every year.” Check out these simple charts below. The first shows a 12% return for 12 years. The second chart shows a 12% average over 12 years. Pay special attention to the final balances in year ten.

Screen Shot 2013-01-17 at 8.40.56 AM

 

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Do you see what happened there? Averaging 12% is much different than earning 12% annually. In fact, in this particular example, earning 12% annually resulted in a 7% cumulative difference in return. This is really really important. Don’t ever let anyone do serious retirement projections for you without discussing what measure they are using.  It can significantly affect your planning toward your retirement (or college savings) goals.

The economy and the financial world have changed

We live in the modern economy. Our historical economy is nearly unrecognizable, in the world today. Technology has brought efficiency, and efficiency has transformed our old economy into what it is today. Our financial markets are completely unrecognizable. Nearly all investment transactions are made by supercomputers in nanoseconds. Speculators and day-traders have flooded the markets and tainted stock valuations. Apple is nearly a $500 billion company. Whatever the 1930’s equivalent of $500 billion was, Apple wouldn’t have been worth that in 1930. Apple, and its valuation, are the product of our modern (not necessarily better) economy.

This is to say that we shouldn’t rely on historical data to drive our investing decisions. The industry line that you hear most often is “past performance is not indicative of future performance.” That’s true. And if that’s true, then past performance from 1930 sure as hell shouldn’t affect your investment decisions 80 years later.

Let’s look at some data. Below you will see the entire historical returns of the S&P 500 from 1926 through 2011. What you will see is that the S&P 500’s historical average hasn’t been 12% since 1929.  (The following charts are courtesy of FinanceAndInvestments.Blogspot.com). By the way, these are ridiculously awesome charts. I wish I had put them together.

S&P 500 1926-1947

S&P 500 1948-1969

S&P 500 1970-1991

S&P 500 1992-2011

What do the charts show? Several things, but among the most important things you will see is that through 2011, the S&P 500 had an average annual return of 9.77%. And over the last 20 years, it’s returned less than 7.81% per year. Please trust me when I tell you that this is significant. In fact, as of right now, you should go ahead and operate on the premise that the S&P 500 averages 7.81%. All of your long-term planning decisions should be based on this, and nothing higher. Unfortunately, many investment, insurance, and retirement projections that are used to sell products and concepts are based on several averages higher than 7.81%. This is a shame. Especially when the consumer has absolutely no concept of what the real averages are.

I took some time this week to ask some industry colleagues their thoughts on this issue. Some still show 12%, some show 10%, and a great deal of them show somewhere in the range of 8%.

“If someone is relying on a 12% return to get them to retirement or pay for their kid’s college and that return doesn’t materialize, they are in a world of hurt with very limited and unattractive options. 7% (assumed rate of return) allows me to focus on what a client can control: their savings rate,” notes fee-only financial advisor Brent Perry from Piedmont Financial Advisors.

Brent is right. The key to this whole equation is being conservative with your return estimate, and instead concentrating on what you can actually control, the savings rate. So in a nutshell, my opinion is that you would be fortunate to average around 7-8% rate of return over a long-term basis. There will be periods in which you get a 20% rate of return.  These are the great times. But there will also be times in which you are getting a -15% rate of return. The 5-year average for the S&P 500 from 1995-1999 was 28.56%. That is just freaking ridiculous. Honestly. People TRIPLED their money in just five years. But this is where the market can be a fickle beast. That “tripled” initial investment from 1995, was reduced by -9%, -11%, and -22% in the following three years (2000, 2001, 2002). $10,000 turned into $35,111.31, and then was reduced to $21,904.12. Sidenote: This was also the advent of day trading. 

If you ever want to retire or fund college for your children, then you will need to invest your money in something. Does that something have to be the stock market? No, not necessarily. But if you do use the stock market, proceed cautiously with reasonable expectations.

 

 

  • http://twitter.com/TomWachowski Tom Wachowski (@TomWachowski)

    Pete, this is one of the best articles ever written about investing. Emphasis was appropriately placed on fees and taxes, too… as these headwinds will,lower the rates above even more (as you pointed out). Great, great, great post!

  • Gary Benhart

    Very good article about investing in stocks. The data in the table certainly shows that timing has always been a key factor to generating acceptable returns on stock investments. Look at the disparity of the average annual returns shown for 2011 over 5 years (-.25%) and 10 years (2.92%) vs. 20 years (7.81%).

    Great post.

  • Pete the Planner

    Thanks, Gary!

  • Paul Jacobs

    The paragraph after the tables of item 3. says the cumulative return is 7%. Try as I might I do not see where this number comes from. 10,000*(1.07)^10 = 19,671.51 which is not the result from either table. Explain please?

  • Pete the Planner

    Excellent question. I didn’t make my point very clear. I’ve edited the post to clarify. The math is ($31,058.38 (12% fixed total) – $28,971.99 (12% avg)) divided by $31,058.38. =6.7% difference between the two numbers. I rounded up to 7%.

  • Tak Nomura

    This whole analysis is bull; the average loss to investors in 2008 was not an annual return of 9.6%. From most analysts reports, the average investor loss was 40%.

    I’d like to see an explanation from reliable sources for the 9.6% annual gain in 2008.

  • Tak Nomura

    Another issue is the fact that people over 70.5 years old must withdraw funds, so the accumulation present is not realistic.

  • Tak Nomura

    Another question about your rate of return. Most financial pundits suggest that the older one gets, the shift from equities to bonds should increase. How do you account for the kinds of rate of return shown on your post for the older generation?

  • Pete the Planner

    Bull it is not. You aren’t reading the chart right. I have the 2008 annual return as -37%. The average is the running average for the history of the market. The number you are referencing is the running lifetime average of the S&P.

  • Pete the Planner

    Only within an IRA. I never set IRA. I’m talking about the stock market. Not IRAs.

  • Pete the Planner

    Returns are returns. I never suggested that people of any age invest in the markets. That’s not the point of the post. Bond rates of return are different, and aren’t reflected on this post because this post is about the S&P 500. Tak, thanks for all your comments on this post. Do you have any more questions?

  • ashley

    Pete, not sure how I found your blog but it makes me want to hug you! This really gives a more reasonable view of what to expect! Thanks!

  • bumperbrown

    refreshing to see unecumbered information. thank you

  • http://www.stephweber.com Steph Weber

    Pete – Do you have a retirement planning calculator that you can recommend?

  • Regina

    Very informative and enlightening! Thank you!

  • Andrew Scarella

    Thanks for the info! Right now I am invested in a fund that’s 60% stocks and 40% bonds. Should I be investing in a fund higher in stocks? I think this is for the long term and I am 35 years old. Thanks.

  • Minikins

    This is so what my gut has been telling me for so long, thanks! Nice to hear it from a professional in the industry. You don’t have to be in the game if you’re happy with smallish returns but not much risk. This is especially true as we may be entering a deflation period. I look forward to reading more of your advice on how to improve returns.