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Retirement calculators (like our handy-dandy Foolish retirement calculator) can be useful tools to help predict when we can throw away our alarm clocks and wave good-bye to the boss forever. Just plug in a few numbers, including the expected annual investment return, and... click... we discover when the real golden years might begin. But exactly which number should we use in these calculations to estimate our future investment returns?
The annual lifetime rate of return depends mainly on two factors: your asset allocation and the return you achieve on each asset class. (We'll exclude the effect of taxes, since most retirement calculators take this into consideration, and since at least some of your retirement money should compound tax-deferred and some may even be tax-free when you withdraw it if you are taking advantage of various retirement account options.)
When we discuss asset allocation, we usually group investments into the three major asset classes: stocks, bonds, and cash (or cash equivalents, such as short-term bonds, money market funds, or certificates of deposit). Sure, there are other investment opportunities out there, such as gold, real estate, and collectibles. But we'll keep it simple here and concentrate on our "big three" asset classes -- stocks, bonds, and cash. Asset allocation quantifies what percentage of our total investment dollars go into each of these three investment categories.
The future returns for bonds and cash are slightly easier to estimate than those of stocks, so we'll take these first. The returns on corporate bonds over 72 years (1926-1998) have averaged 5.7% annually; those for short-term U.S. Treasury bills (our proxy for a cash-equivalent investment) averaged 3.7%. For comparison, the average annual inflation rate during that same period was 3.1%.
I think it's reasonable for future planning to assume that bonds will return close to their historical average of 6%, while investments in cash equivalents will return about 4%. Yes, future returns may differ from these historical averages, but I'll be danged if you, me, or anyone else can predict interest rates for next month, no less the next quarter century. We'll have to be content to stick to historical returns as a guide for our future estimates.
Can astute investors outperform the averages for bonds or cash equivalents? No doubt some can. But there's also relatively little extra value gained by digging deeply into the nuances of these investments, at least compared to what might be gained from intelligent stock picking. The disparity of returns for individual bonds is much narrower than for individual stocks.
For instance, when was the last time someone offered you a really hot bond tip? T-bill rates are fixed by the government. Sure, you can shop around for a great deal on certificates of deposit, but you're unlikely to gain much more than a few percentage points for your efforts.
When we talk about our estimated future returns on stocks, however, things get a little more complicated. There are two main factors to consider: the performance of stocks as a group, and how our individual portfolios will vary from the average performance of stocks in general.
If you've come here looking for stock market prognostications for the next 30 years, look elsewhere. My crystal ball is fading, and I'm not convinced that anyone has one that is worth a darn. For every doomsday prediction offered by pessimists like by Professor Robert Shiller in Irrational Exuberance, you'll find an optimistic scenario -- James Glassman's Dow 36,000, for instance, or Harry S. Dent's The Roaring 2000s.
From 1926 to 1998, large company stocks, as measured by the S&P 500 Index, have gained 11.2% annually -- almost double that of bonds, and about triple that of Treasury bills. Since neither I nor anyone else can accurately predict future market returns, I'd say an 11% figure is as good an estimate for future average stock returns as any. Using this 11% figure as a baseline for stock returns, the next question becomes: Will your actual portfolio perform better or worse than average?
When trying to estimate your long-term future returns, why not just take your average returns for the past two, five, or even ten years and plug in that number? That would be a big mistake. The returns for U.S. stocks over the last decade have been an aberration, with the S&P 500 Index outperforming the historical averages by over seven percentage points annually. That doesn't mean future returns won't be similar to those of the recent past. It's just highly unlikely.
If you don't see yourself generating above-average returns, I'd just use the historical average of 11% for the estimated future returns of the stock portion of your portfolio. It doesn't make sense to plan for sub-par performance when par can be had with so little effort. If you don't think you can outperform the averages in the long run (and that includes expenses and tax considerations), I wouldn't even try. Just invest in an index fund that mimics the S&P 500 or buy S&P Depository Receipts. If you can't beat Mr. S&P, you might as well join him.
But should Fools be able to plan for future stock returns that are higher than the long-term averages? The Foolish Four has returned almost 20% annually since 1961, outpacing the S&P 500 Index by over seven percentage points. And some of the screens in the Workshop have backtested returns of over 25% since 1969, easily doubling the S&P 500. Plug 25% annual returns into an investment calculator for a period of 30 years and start salivating.
According to the Foolish Savings Calculator, if you start with $5,000, add $300 monthly, and achieve an average return of 25% per year, your account will be worth over $11 million in 30 years if invested in a tax-advantaged account. Ka-Ching!
Let's stop the drooling and return to earth. Even though many of our mechanical strategies featured in Fooldom have easily whipped the market averages, I don't think anyone should plan for such returns going forward. First, most of these strategies have been backtested for periods that include the recent two decades, a period that's witnessed unprecedented market returns.
Also, there's a concept called regression toward the mean. Regression toward the mean predicts that if the initial performance of a group differs markedly from the average, on retesting the group will tend to perform more like the group average than it did initially. In other words, if we identify an outstanding group of stocks using mechanical investing techniques, it's likely that future returns will be less favorable. This doesn't exclude outstanding future results, but rather predicts they may be less outstanding than the initial results. Click here for more details on this important statistical concept.
I don't think it's unreasonable for diligent, experienced Fools who've had a track record of successfully beating the market averages to plan for this going forward, especially if they have the discipline to use some of our well-tried mechanical investing models like the Foolish Four or Beating the S&P. I personally plug a number of 15% for stock returns into such retirement calculators.
I already know I'll get a bunch of e-mails about this 15% number. Is such a return wildly optimistic? Do I have such hubris to think a cardiologist can consistently outperform the market averages by four percentage points a year, even when the large majority of professionally trained mutual fund managers underperform? Maybe. But 15% is considerably lower than many of the long-term backtested returns for mechanical models. And four of the five real-money portfolios followed officially here in Fooldom have beaten the markets since their inception (with the other one, the Boring Portfolio, close behind the S&P). These five real-money portfolios have beaten the S&P 500 by an average of over 10 percentage points, although over a relatively short time span.
So, maybe four percentage points a year isn't completely unreasonable for a seasoned investor. And it sure doesn't make sense to go through all these machinations about learning to pick individual stocks if you don't think you can beat the averages in the long run.
Next week we'll put the final pieces of the puzzle together when we talk a little bit more about asset allocation, as well as a few caveats about this whole process.
Beating the S&P year-to-date returns
(as of 05-23-00):
Bank One <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ONE)") else Response.Write("(NYSE: ONE)") end if %> -0.4%
PepsiCo <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PEP)") else Response.Write("(NYSE: PEP)") end if %> +12.3%
Ford Motor Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: F)") else Response.Write("(NYSE: F)") end if %> -1.8%
Bank of America <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BAC)") else Response.Write("(NYSE: BAC)") end if %> +5.7%
Fannie Mae <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FNM)") else Response.Write("(NYSE: FNM)") end if %> -7.6%
Beating the S&P +1.6%
Standard & Poor's 500 Index -6.5%
Compound Annual Growth Rate from 1-2-87:
Beating the S&P +23.7%
S&P 500 +16.9%
$10,000 invested on 1-2-87 now equals:
Beating the S&P $170,500
S&P 500 $79,000