Heading into this year, there has been a lot of skepticism about the prospects for equity returns going forward.
On one hand, we’ve all heard this story before.
Over the past decade, pretty much everyone has hummed the “market is overvalued” tune at some point – all while the S&P has continued its relentless march upwards.
On the other hand, it makes total sense.
Long-term stock market returns are somewhere around 8-10%. Since 2010, the S&P has delivered an annualized return of about 15%.
It would be silly to assume we will keep seeing this kind of performance ad infinitum.
And if I was a betting man, I’d probably side with Vanguard’s take on future returns below instead of assuming the bull run will continue in perpetuity:
Nominal Future Returns
That being said, there’s no need to give up your dreams of financial independence just because the returns may be lower for the next year (or ten).
Below are some thoughts on optimizing your wealth-building strategy in an era of below-average market returns.
Back To Basics
Remember – there are three fundamental levers you can pull in order to compound your net worth in the stock market.
To begin with, there’s the amount of money you are putting to work.
Then, there is the return you generate on those investments (how hard that money works).
Finally, there’s the amount of time you let those investments compound (how long that money works).
There isn’t much you can do to influence market returns. They are what they are (and right now, they are mighty frustrating!)
You can, however, play with the other two variables.
One option is to increase the amount of money you are putting aside. To do this, you can either increase your savings rate or increase your earnings.
Assuming you’ve got your budget under reasonable control, increasing your savings rate may be a tough ask. This is especially true when prices are rising 5-10% a year.
The good news is that this higher inflation is playing out against the backdrop of a pretty robust job market, which makes it much easier to negotiate a raise or find a better paid job.
If you can save 50% – 75% of every incremental dollar you make, you’ll not only juice your savings rate, but will have some extra money left over to spend on whatever your heart desires.
In other words, it’s a win-win.
As an aside, there’s a special mention here for ANY kind of consumer debt.
Financing a car or a holiday at 15% is a BAD idea to begin with. Doing so when the equity market is returning 3% a year is like playing Russian roulette with a fully loaded revolver.
Please don’t. And if you’ve done it already, do the best you can to pay it off as quickly as possible.
Max Out Tax-Advantaged Accounts
While I think returns may be lower for a while, I don’t subscribe to the notion of a permanent reduction.
That being said, many people do.
If you’re in that camp, the natural consequence is to channel most, if not all, contributions into your tax-advantaged accounts like workplace pensions and 401(k)s.
In a world of 8-10% returns, you can probably afford to forgo some of the employer match, putting money aside into your GIAs (general investment accounts) instead.
But if you think we live in an era of 3-4% returns, you can hardly afford to pass up on the opportunity to double or triple your money on the spot:
Re-evaluate Real Estate vs. Stock Market
One reason I am such a big fan of real estate is its ability to deliver higher long-term returns as compared to equities.
Yes, it’s not apples and oranges.
Real estate is usually more hands-on, even if you have a great property manager.
Ideally, you also want to own a reasonably sized portfolio of properties in order to diversify away your risk.
But in return, you can get 10-15% annual returns – and that’s before any home runs.
It might not seem like much – but those few incremental points of return make a tremendous difference over the years:
And, of course, the bifurcation becomes even starker if the markets were to return 4% instead of 8% going forward.
As I’ve mentioned before, property isn’t for everyone. That being said, it’s a great way to build wealth – and your returns are largely uncorrelated with the equity markets.
Reconsider Investing vs Mortgage Repayment
The other decision you may want to reconsider is how quickly you repay your mortgage.
On the surface of it, it’s a straightforward one.
If you expect equities to return 8% while your mortgage carries an interest rate of 2%, investing will always leave you financially (if not psychologically) better off.
When expected long-term stock market returns decline, that math gets fuzzier, thanks to factors like taxes (both on investment and regular income), asset allocations, early retirement aspirations, views on SWRs and so on.
However, even if future market returns are significantly lower vs history, that doesn’t necessarily make early mortgage repayment the preferred option.
The reason, once again, is inflation.
Right now, we live in a world where inflation runs at 5%+ per year. At the same time, you can lock in a long-term mortgage for significantly less than that.
In the US, you can get a 30-year fixed rate for just over 3% at the moment (do note the recent increase):
In the UK, 30-year mortgages don’t yet exist (though that might soon change). However, you can lock in a fixed rate of just 2% for the next 10 years.
And in Continental Europe, I’ve heard of people taking out 20-year fixed rate mortgages for about 1.5%.
Now, I don’t know where inflation will be over the next decade – or three.
But if you think current levels of inflation will persist, borrowing money at 3% to finance an asset that will grow at least 5% (as real estate typically tracks inflation) is basically finance 101.
Alternative Income Streams
Lower equity returns can also change the thinking around alternative income streams.
Let’s say you could take on a part-time job that pays $500 a month.
One option is to invest that money in a nicely diversified, low-cost index. Do that for long enough, and magic will happen.
But what if you don’t have a 40-year runway? What if you only have 10-15 years left in the workforce – and you expect the returns to be subpar during that time period?
Well, one way to approach it is to consider that your equity investments will work for you long after retirement. It’s not like you’ll sell all of your equities the day you pull the plug.
Equally, you may be better off utilizing your time and money to build up a side income stream.
Being able to generate $500 – $1,000 a month in incremental income may not sound like much.
But assuming a 3% SWR, that $1k a month has a headline value of $400k.
And at a 2% SWR, the value goes up $600k.
Something to ponder.
Finally – and provided you’ve got a long enough time horizon – you may well choose to double down on the market.
The early retirees of today are the ones who kept buying equities back in the 2000s – one of the worst decades ever to be an investor.
Those who stayed the course through the dot-com crash AND the GFC were subsequently rewarded with the mother of all bull markets.
For all we know, the early retirement class of 2040 may well be matriculating today – but only if you keep the faith.
As always, thank you for reading – and happy investing.
About Banker On Fire
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Banker On FIRE is an 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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