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In the first installment of this series, we saw how your investment returns can shave years, if not decades, off your potential retirement age. Last week, we discussed how these returns depend mainly on two factors: the mix of assets you have in your portfolio (that is, your percentage of stocks, bonds, and cash equivalents), and the average return that you can achieve for each asset class.
We've seen that bonds have returned about 6% annually on average since 1926. Short-term Treasury bills (our surrogate for cash) have returned 4% over the same period, just slightly ahead of the inflation rate of 3%. Stocks, the gold medal winners, returned about 11.3% annually since 1926.
Of course, the returns you achieve from your stocks may well deviate from the 11% historical average. Going forward, the return of stocks as a group may differ from this 11% number substantially. For instance, since 1961, the S&P 500 has averaged anywhere from 7% to 18% annually over any consecutive 20-year period. For shorter periods the range of returns becomes even greater. Since 1961, the S&P 500 averaged from 1% to 19% over any 10-year period, and from -2% to 29% over any 5-year period. You pays your money and you takes your chances.
We also discussed last week that any individual's stock returns may deviate significantly even from these averages. We Fools -- sometimes with the help of mechanical investments like the Foolish Four and Beating the S&P -- hope to do better than average. But there are no guarantees.
Once we've learned to estimate the future returns for our stock investments, there's another factor that will determine our overall investment returns. Our ultimate future returns will depend on how we allocate our assets into the main categories of investments (stocks, bonds, or cash), and the expected return on each of these asset classes.
Should we be invested completely in stocks? Many Fools believe the answer to this question is "yes" -- that is, yes for truly long-term investments that we don't need to touch for at least 10 years. But we all need a cash safety net for emergencies. We also shouldn't rely too heavily on volatile stocks for any funds we'll need in the short-term -- a down payment on a house or tuition, for example. Here's one Foolish take on asset allocation.
To get your personalized final number, your future investment returns can be estimated by this formula:
Annual Investment Return (%) = %Cash*(.04) + %Bonds*(.06) + %Stocks*(X/100)
where X represents your personalized expected annual returns for stocks, as we discussed last week. Just plug the percentage of your assets you expect to keep in cash, bonds, and stocks, and you're set.
For instance, let's assume you're a novice investor who is just starting out, dipping your toes into those chilly investment seas. As a beginner, you decide to invest in an index mutual fund that mimics the S&P 500, which historically has returned 11%. Out of a portfolio of $10,000, you decide you'll need to keep $5000, or 50% of your portfolio, in cash to cover unexpected emergencies. You've also allocated $2000 (or 20% of your portfolio) to a fund dedicated to a future down payment on a house, which you've invested in a couple of bonds. The remaining $3000 (30% of your $10,000 portfolio) will be invested for the long-term, in stocks.
What's an estimate for your future returns? Our equation tells us that your annual investment return = %Cash*(.04) + %Bonds*(.06) + %Stocks*(X/100), or 50*(.04) + 20*(.06) + 30*(11/100) = 2.0 +1.2 + 3.3 = 6.5%. Assuming this asset allocation remains stable over the years (and it probably won't -- see below), your expected investment return is 6.5% on the full $10,000.
Now for a few comments and caveats. Many retirement calculators will let you individualize your estimated returns for your different accounts. Therefore, if you intend to invest your IRA or 401(k) solely in stocks, just plug in your estimated return for the stock portion of your investments.
The investment process is not static. Your asset allocation may vary considerably over your lifetime. For instance, when starting out, most of your investments might be allocated to cash equivalents, until you've built up your safety net. Or you may be saving up for a special purchase in a few years, which will also require a lower stock allocation. Over time, as these special needs are met (and as the stock portion of your portfolio outperforms that of your other investments), the percentage of your portfolio in stocks will often increase.
It's important to realize that any projections made using returns estimates are just "best guess" averages, based mostly on past market history. Your actual results may, and probably will, deviate significantly from these averages. These forecasts are based on averages around a bell curve. As such, the chances of exactly achieving even the most likely result are relatively small.
Finally, since estimating future returns is a very inexact science, we should be wary of how we use such retirement calculators. The calculators can be helpful as a general planning instrument, but I wouldn't use them to fix my retirement date in stone. Running these calculators using different scenarios is often instructive and helpful. Until that time-travel machine I've been working on in my basement gets perfected, though, we're just going to have to live with some uncertainty.
But uncertainty isn't all bad. Without it, life would be one big yawn. To quote Nobel Prize-winning physicist Richard Feynman:
Beating the S&P year-to-date returns
Compound Annual Growth Rate from 1-2-87:
Beating the S&P +23.8%
S&P 500 +17.1%
$10,000 invested on 1-2-87 now equals:
Beating the S&P $175,800
S&P 500 $82,800
I've learned how to live without knowing. I don't have to be sure I'm succeeding, and as I said before about science, I think my life is fuller because I realize that I don't know what I'm doing.
In a sense, when we plan for the future, we all don't know what we're doing. We take our best "guesstimates" and hope for the best. Going out on the field with a game plan surely is better than playing without one, even if we may need to revise that plan many times over.
(as of 05-30-00):
Bank One <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ONE)") else Response.Write("(NYSE: ONE)") end if %> +4.8%
PepsiCo <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PEP)") else Response.Write("(NYSE: PEP)") end if %> +16.7%
Ford Motor Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: F)") else Response.Write("(NYSE: F)") end if %> -6.1%
Bank of America <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BAC)") else Response.Write("(NYSE: BAC)") end if %> +10.5%
Fannie Mae <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FNM)") else Response.Write("(NYSE: FNM)") end if %> -2.5%
Beating the S&P +4.7%
Standard & Poor's 500 Index -3.2%