Mail Bag: Return Assumptions in Your About.com Articles
All morning long, I’ve been getting letters in the inbox about my “latest” article at Investing for Beginners. I have no idea what they are talking about because the article in question, which isn’t even an article, it is a “quick tip” template that was meant as a side bar to another piece, was published years ago and has not been featured anywhere on either of sites. Rather, it is buried in the archives if you want to read it as a stand-alone piece so why people are under the impression that I must have 1. Just written it, or 2. Just featured it is a mystery to me.
Still, given the overwhelming amount of messages I’ve received about the piece, I’m going to publicly post what has now become almost a cut-and-paste response.
Joshua,
In your newest article, you talk about how a person could save $197 per paycheck for a lifetime and end up with $4,300,000 at a 10% rate of return.
That is way too high. Many investments return only 5% to 6% per year. Why did you use that return assumption?
Thanks,
Lane
Lane,
The return assumption is taken from the statistical gold standard, the Ibbotson & Associates SBBI Classic yearbook: Market Results for Stocks, Bonds, Bills, and Inflation 1926-Present, which examines the nominal returns of nearly every major equity and bond class on an individual, 3 year, 5 year, and up to 25 year rolling basis.
It is the return that one would expect if he or she followed a very specific formula:
- Picked a very attractive, low-cost index fund with almost no expenses that held high quality, large capitalization stocks. Nearly all 401(k) plans offer these as the core fund choice. The most popular is the Vanguard S&P 500 Index Fund. (Update: Be aware of quiet changes in the methodology that may make future return assumptions differ from past return experience.)
- Dollar cost averaged into it on a monthly basis so you captured the highs and lows
- Reinvested the dividends so the money distributed by the underlying businesses got plowed back into more shares
- Didn’t pay taxes (e.g., used a tax shelter such as an IRA, or in the case of this article, a 401(k) plan)
- Kept up with it for an entire career
This formula, had it been followed in all long-term rolling periods from 1926 to today, would have produced average rates of return for large capitalization stocks of around 10% compounded. That is because the market bubbles (e.g., 1929, 2000) are more than made up for by the market busts (e.g., 1933 and 2007) when the regular contributions and reinvested dividends are able to buy up shares at once-in-a-generation cheap prices.
It wouldn’t work if you were dumping a lump sum in the market, especially at today’s prices. I don’t think one can reasonably expect 10% rates of return on present stock market valuations – the ratio of the total stock market to GNP is too high, for one. But that aside, I do think that 50+ years from now, such a program started today should, if history is any guide, provide roughly 10% nominal returns for the reasons already cited. That is a vital distinction.
To put it more directly: It is not a mathematically inconsistent nor historically unreasonable position to posit that a basket of stocks bought today with a lump sum would produce 6% to 7% nominally over the next ten years due to present valuation and that a dollar cost averaging program started today will produce 10% returns over the next 25+ years as the regular purchases and reinvested dividends averaged out the highs and lows of market volatility.
I always strive to use the best academic data available and not my personal opinion. You can buy a copy of the statistical reference here, which is the most accurate academic and professional source of long-term asset class returns available anywhere in the world: http://corporate.
Sincerely,
Joshua
P.S. If you can provide any academic study that shows long-term 25-year rolling periods of equity ownership in the United States have produced 5% to 6% for those following a program comparable to the one laid out here, I’ll change the article. (I’ll save you the time: You can’t because it doesn’t exist. If it did, I would have suggested people take the 401(k) money and roll it into a self-directed plan to do something like buy a high quality office building or apartment complex that produced a steady stream of rents at 10% capitalization rate.)
