A reader asks:
What REAL rate of return is best to use for retirement forecasting? I always read that stocks have an average return of ~10%, but I'm curious what actual return is best to use to account for inflation in retirement planning.
One of the most important aspects of any successful investment plan is setting reasonable expectations from the beginning. The difficult part of this equation is that most of those expectations are guesses and are likely wrong.
The obvious reason is that the future is both unknowable and unpredictable.
When it comes to the stock market, the best thing you can do is analyze the past, think about the present, and make educated guesses about the future.
I like how this reader asks for real returns because those are the only ones that matter in the long run. Luckily, the stock market has historically been a wonderful hedge against inflation.
Here are some updated long-term inflation-adjusted returns for stocks, bonds, cash, gold and dollars going back more than 200 years. Actions for the long term by Jeremy Siegel and Jeremy Schwartz:
Stocks are the big winners in the long term (hence the name of the book).1
The purchasing power of the dollar has been decimated, but that is due to inflation. You shouldn't get a return on your money just by burying it in your backyard. You have to take risks to gain a reward.
Aswath Damodaran has annual data for stocks, bonds, and cash going back to 1928. Here are the actual returns for those three asset classes over that time period:
That's pretty close for stocks, but slightly lower for bonds and cash.
What's interesting about long-term real stock market returns is how relatively stable they have been regardless of the economic environment.
The big question is this: can we use historical stock performance to set expectations for the future?
The honest answer is that we don't know for sure. No one can tell you what the future holds.
I'm pretty sure the stock market will continue to outperform bonds and cash over the long term, but no one can be sure what that premium will be. That's simply a function of risk.
Many people assume that the fact that valuations have increased over time should mean lower returns in the future. It is enough to observe the upward oscillation of the CAPE ratio over time:
My take here is that you can argue that stock market returns can and should be lower in the future, but it's not really based on valuations per se. Rather, it is based on the idea that accessing the stock market was much more difficult in the past.
There were much higher barriers to entry.
Costs were higher and the financial system was more unstable. Therefore, investors rightly demanded higher returns on a gross basis. But net returns in the past were probably much lower, since trading costs, fees and expense ratios were much higher.
Even if gross returns are lower in the future, it is much easier to earn market returns on a net basis through index funds, ETFs, and commission-free trading. Additionally, there were no tax-deferred retirement accounts before about 1980.
The best case for lower returns going forward is probably the United States. Our stock market has been the clear winner for the last 120 years relative to the rest of the world:
I would not do it bet against the United States of America but we cannot expect the performance to be repeated either.
I guess what I'm trying to say here is that the best thing you can do is use a range of real returns to set expectations for the future of your portfolio. I'd say something in the range of 5-6% real is reasonable based on current valuation levels:
The earnings yield is the inverse of the P/E ratio, which currently stands at around 5.2%.2
If things go better than expected, you can adjust your plan accordingly.
If things go worse than expected, you can adjust your plan accordingly.
Life would be much easier if risky assets offered us fixed future returns. But then they would not be risk assets and certainly would not offer a premium over other asset classes or the inflation rate.
One of the main reasons stocks offer this premium is that we simply don't know exactly what their future returns will be.
Jeremy Schwartz joined me on this week's Ask the Compound to answer this question and talk about long-term stocks, expected returns, international stocks, currency hedging, and why the inflation rate is actually lower than it seems:
Other readings:
Do valuations matter for the stock market?
1I'd say real estate would be a close second on this list from an inflation hedging perspective, but long-term returns are much harder to calculate when you include things like ancillary costs, mortgage rates, refinancing, leverage, etc. .
2And this is real since stocks are a real asset.
