One of the things that I always ask clients (in fact it’s on my initial questionnaire that potential clients fill out) is “What is your expected return from your investments?” It can be pretty insightful to see what people are thinking that they should be able to receive in returns from their investments – I’ve seen everything ranging from 2% up to 25%.
In general, what I see in response to this question is high – much too high to be realistic. If you look at the stock market over long periods of time, you’ll see that the annualized return over the past 100 years was roughly 9.4% (including reinvested dividends), for example. What’s important is to understand how market returns are composed, in order to put it all into context.
How Market Returns Are Composed
Stock market returns are made up of several components: the amount of return that stocks earn above the “risk-free” rate of return of Treasury Bills (known as the equity premium), plus the risk free rate of return, plus the rate of inflation. This is usually expressed as an equation:
Inflation + Risk-Free Rate + Equity Premium = Equity Return
If you looked at present figures, you’d see that Inflation is presently running around 2.2% (CPI-U, since April 2009). The Risk-Free Rate is presently something like 0.7%, and the historic Equity Premium is around 4.8%. Adding all this together we come up with
2.2% + 0.7% + 4.8% = 7.7%
The key to all of this is not exactly what figure we come up with, but to give us an idea of what composes the return figures. If you happen to receive a return of 7.7%, that would be quite a coincidence indeed – this calculation gives us an expectation to aim for, and that is all.
But understanding that inflation is one of the primary components of this equation, along with the rate of return on Treasury Bills, helps us to understand why low inflation and low interest rates (like we’re experiencing these days) often equates to lower than the historic average in terms of overall stock market returns.
Going back to the last 100 years’ figures, we see that the rate of inflation averaged 3.13% during that period. If we consider that the risk-free return for the period was roughly 0.9%, we calculate that the Equity Premium for the period was approximately 5.36% as such:
9.41% – 3.13% – 0.9% = 5.36%
This reflects only a 0.56% differential in the Equity Premium between today’s figures and the historic averages. The past 50 years experienced a higher rate of inflation (4.08%) with approximately the same average return (9.45%) and risk-free rate (0.9%), which suggests that the Equity Premium has been lower during that period, somewhere around 4.47%, which is still significant.
But It’s The Portfolio We’re Talking About…
Keep in mind, we’re not only talking about stock market returns – we’re talking about overall portfolio return expectations. If we assume that the averaged-out rate of return that we can expect (in terms of premium over inflation and risk-free returns) is reduced by 2-3%, then in today’s marketplace with the 7.7% expected equity return, our blended return should range between 3% to 7.7% across the spectrum.
That may seem anemic, especially in the context of the crazy 15%, 18% or 20% returns we’ve seen in years past – but as we saw, those returns were based on some crazy bubble-based speculations. The expectation of returns in those periods had no basis in reality… so welcome back to reality. The point is that you need to be realistic about the returns we expect. There’s no benefit to you by expecting a 20% return when it’s highly unlikely to be delivered. Don’t get me wrong, I believe in being optimistic – but not when it can be detrimental to your financial life.
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