The topic of future stock market returns has got to be one of the most popular stones of contention in the personal finance community.
Everyone agrees that historically, those returns looked pretty damn good, as illustrated by my one of favourite charts:
That being said, the world has changed.
Things ain’t as good as they used to be, the past does not predict the future (and will you PLEASE look at Japan!)
This isn’t a theoretical argument, either.
The beauty (and danger) of compounding is that over long periods of time, even tiny changes in returns can have an outsized impact on performance:
When striving to build wealth and reach financial independence, it’s best to focus on the journey and not the outcome.
Still, it is also quite helpful to know how long the journey will take, even approximately. And for this, you’ve got to stick some kind of a value in the “returns” cell of your net worth spreadsheet.
Admittedly, I am an optimist by heart. Life is much easier to live if you don’t expect to get whacked by a baseball bat every time you pass a dark alleyway.
Even so, I struggle to see future stock market returns exceeding 10% going forward.
Here are four reasons why.
Let’s start with the elephant in the room:
S&P 500 Historical P/E Ratio
Over the past 100+ years, the mean P/E ratio for the S&P 500 stood at around 16x, give or take.
You don’t need to be a genius to figure out that today’s levels of 40x+ are not sustainable.
However, you could also make a very strong argument that valuations don’t really matter in today’s environment.
First of all, you’ve got to account for whether the P/E ratio you are looking at is backward or forward-looking.
For example, the chart above uses trailing twelve months’ earnings, which have been significantly depressed.
Covid is obviously a big reason. However, management teams have also contributed here, taking every single write-off possible in order to ensure the recovery looks as robust as possible.
On the contrary, a forward-looking ratio (based on the next twelve months’ earnings) stands at about 21-22x right now, depending on which estimates you are looking at.
Still well above historical averages.
That being said, large swathes of the economy are just beginning to recover from the pandemic. They certainly won’t be firing on all cylinders over the next year.
For all we know, by the time the dust settles valuations might not be as big of a problem as people think right now.
#2: Life Expectancy
The topic of longer lifespans and the impact it has on our return requirements doesn’t get nearly as much attention as it should.
Imagine a twenty-year-old who knows they might not be around to see his thirtieth birthday.
Not exactly an ideal stock market investor, what with the long-term horizon and the need to ride out booms and busts to enjoy a wealthy retirement.
And to the extent such a twenty-year-old would entertain investment opportunities in the first place, you can rest assured his return expectations would be far north of the 10% delivered by the market in the past.
Now imagine a world where life expectancy goes up to two hundred years.
Rest assured that two things would happen in pretty short order:
- Investors would become much more tolerant of risk, given they’ve got a much longer investing horizon; and,
- Investors would accept a much lower return, given the impact of compounding
Over the past 70 years, the life expectancy in North America has gone up about 20%, from just under 70 to around 85 years.
For all we know, that could well be a driver of lower return requirements which in turn leads to higher valuations we are seeing today.
And that’s before you consider emerging markets, which have seen an even more pronounced increase in life expectancy and are contributing an ever-increasing share of equity inflows.
#3: Democratization Of Investing
It’s all fine and dandy to look at charts like the one at the beginning of this post.
Wouldn’t life be grand if we could all go back in time and start investing back in the 1930s or even 1950s?
But let’s not forget what equity investing actually entailed back in the day.
First of all, you had to be relatively affluent – certainly affluent enough to have a bank and brokerage account and execute minimum order sizes (100 shares at a minimum).
Second of all, you had to be educated enough about investing (remember – this is before the era of wonderful investing blogs like this one!)
Provided you cleared the first two hurdles, you also had to bear much higher costs.
Things always look easier in hindsight, but no one talks about $100+ trade fees, egregious mutual fund fees (no index funds, remember?), and high brokerage costs.
Yes, the market delivered historical returns of 10%+, but a big chunk of that disappeared in the pockets of all the finance industry intermediaries.
For all we know, while overall market returns have trended lower over time, investor-level returns might have been insulated by a corresponding reduction in investing costs.
#4: Fewer Busts
For a long-term investor, staying the course through stock market corrections is by far the biggest driver of returns over time.
At the very least, you should not sell or pause your regular contributions.
But it’s those investors who actually rebalance into equities during rough stretches (easier said than done) that see outsized returns on their investments.
The real money in the market isn’t made when the skies are blue. On the contrary, wealth is generated in periods like the 1930s, 1970s, late 2000s, and most recently, March – April 2020.
As central banks and governments have become more effective at preventing deep market drawdowns – and more willing to do so, opportunities to buy equities on the cheap have been drying up.
Last year’s Covid crash was the shortest bear market in history.
While some folks managed to load up on equities, many others had been caught flat-footed, missing out on one of the best entry points in recent history.
A chance to drive outsized long-term returns, gone with the wind.
As ever in investing, it might be helpful to take things with a dose of pragmatism.
First of all, while we can have a hunch about how things will unfold in the future, absolutely no one knows what is actually going to happen.
Perhaps technological progress will usher us into an unprecedented age of prosperity, which will ultimately lift asset values worldwide.
But even if that doesn’t happen, the bottom line is that we really haven’t got that many options.
Yes, there’s real estate.
Which leaves the stock market as your best option to create sustainable, long-term wealth.
My personal hunch is that the chances of future stock market returns exceeding 10% going forward are pretty slim.
Equally, I don’t feel that the 5 – 6% range some folks advocate is reasonable either.
Applying a haircut of 40% – 50% to historical performance just feels too onerous. Adjusted for inflation, that would imply real returns somewhere in the 2-3% range.
This is why I use 8% for my own planning purposes, as well as here on the blog.
You may well want to take a more conservative view. There is some benefit to being surprised on the upside.
But the broader point to remember is that lower future stock market returns don’t necessarily spell doom and gloom for your portfolio.
There are proven, effective strategies to mitigate against the above.
However, it all starts with acknowledging, and planning for the possibility that future stock market returns might not be as good as they were in the past.
Thank you for reading – and happy investing!
About Banker On Fire
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Banker On FIRE is a London-based M&A (mergers and acquisitions) investment banker. I am passionate about capital markets, behavioural economics, financial independence, and living the best life possible.
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