If one were to distill the most contentious question in stock market investing, it would boil down to this:
“What is a reasonable expectation for stock market returns going forward?”
Your take on the question above impacts a multitude of things.
First and foremost, it drives your asset allocation decisions.
Do you go all-in on equities, or do you allocate a portion of your portfolio to real estate?
Then there’s your investment horizon.
If you take a conservative view on stock market returns, the implication is that it will take you longer to reach financial independence.
If you have a more optimistic view, you will expect to hit FI sooner.
Once again, this has implications for how you construct your portfolio and weigh it between tax-deferred and taxable vehicles, not to mention a host of life decisions.
Finally, there’s the magic number itself. How much money do you actually need to retire?
Those who believe stock market returns will be lower going forward posit that the traditional safe withdrawal rate of 4% no longer applies.
If you are in that camp, you may want to build a margin of safety into your planning.
Of course, no one knows how the stock market will behave going forward.
Not you, not me, and shockingly not even the Twitter bro selling that Gumroad course on making millions overnight.
But that doesn’t mean we shouldn’t establish at least an approximate mental benchmark for where stock market returns might end up going forward – and use it for planning purposes.
If things turn out better than we expected – hey ho! Not going to beat yourself up over that one.
If they don’t – well, that doesn’t make investing a waste of time. It just means we’ll have to re-calibrate and move on.
And the good news is that we have a pretty robust set of historical data that can help us form an opinion.
Random Walk Down Memory Lane
I have previously written about the challenge of picking the right benchmark for historic stock market returns.
It boils down to the fact that the S&P 500 is the best sample we can get.
The Dow, comprised of 30 stocks, just isn’t sufficiently diversified. World trackers, on the other hand, simply haven’t been around long enough.
So let’s have a look at the distribution of S&P 500 returns between 1926 (earliest data available) and 2019:
At first glance, you may think that the returns are all over the place. And guess what – they are.
There’s simply no rhyme or reason to short term stock market moves.
However, if there’s one thing that should jump out at you it’s the fact that there are far more dots in the top half of the graph than in the bottom one.
In other words, the S&P 500 lost money in 25 of the past 94 years, or roughly 25% of the time.
In the other 69 years, or three-quarters of the time, it has posted gains.
Sometimes those gains are minuscule, just squeezing past the zero mark.
But in many other years, the gains were nothing short of respectable. In fact, in 20 of the past 94 years, the annual gains have exceeded 30%.
The Power Of Time…
Imagine you had a great-grandparent foresightful enough to invest $100 in the S&P way back in 1926.
If they had just left it there for the next 94 years, you would have collected a cool $923k at the end of 2019.
All in, that represents an annual nominal return of 10.2%.
Now, don’t get me wrong, $100 was actually a serious chunk of change back then. Assuming a 3% inflation rate, that’s about $1,600 in today’s money.
However, I don’t have to tell you that $923k happens to be significantly more than $1,600, any way you cut it.
The problem with examples like the one above is that no one actually invests that way.
Instead, the vast majority of people make regular contributions – whether through their workplace pensions or 401(k) plans.
Let’s imagine that the same great-grandparent of yours kept topping up the brokerage account with $100 on January 1st of every year.
By the time you had gotten around to cashing in that portfolio at the end of 2019, it would have grown to a cool $14.5m.
And in this scenario, the annualized returns would have been even better, adding up to around 10.7%.
That’s because over the past century or so, we’ve had some pretty severe market downturns.
Upsetting as they may have been, they actually presented a wonderful opportunity to buy stocks on the cheap.
It may sound counterintuitive, but a regular investor staying the course realizes a massive long-term benefit every single time the market corrects to the downside.
Wind Of Change
We have now established that over extremely long periods of time, the stock market has returned somewhere between 10% and 11%, in nominal terms.
What you will see, however, is that most people use a number that’s far lower than that.
My own “base case” assumption is 8%, well short of the 10% long-term returns.
And yet, I’ve taken some (polite) heat from commenters who consider that number too high.
What’s going on here?
To answer that question, let’s have a look at some of the more recent stock market performance, which I summarize in the table below:
If you were lucky enough to start investing in 1969 or 1979 (and kept going), you would be sitting pretty with ~11% annualized returns.
The generation that only managed to get into the stock market in the late 1980s or 1990s hasn’t done quite so well, though they won’t exactly be heading for the soup kitchen either.
And while the returns over the past decade are nothing short of spectacular, they encapsulate one the greatest bull run of all times. I wouldn’t hold your breath for another one.
There’s another way of looking at recent stock market performance.
The table below shows what your returns would have been in each ten-year period starting in 1989.
For example, if you had started your investing journey in 1989, investing for the next 10 years and cashing out in 1999, you would have cleared a whopping 20.7% return.
That’s because you would have ridden the bull run of the 1990s – and cashed out just before the dot-com bubble finally burst.
For those starting towards the end of the 1990s, things didn’t look so good.
If you started in 1998, you could have plowed on for the next 10 years and still lost money to the tune of 2.8% a year.
Catching the wrong end of the dot com bubble and the Great Financial Crisis will do that to you.
That being said, the average return over that time period still worked out to 8.6%.
Not too shabby for a stretch of time encompassing two massive stock market crises, a number of wars, and an unprecedented terror attack on American soil.
What Happens Next?
I certainly won’t pretend to know the answer. We could be in for a period of stellar returns.
Alternatively, we could run into another “lost decade” like the one we had in the 2000s – and end up barely breaking even.
The problem is that there has never been a time when investing in stocks seemed like a good idea.
Sometimes the valuations look too high. Sometimes the economy looks too bad.
And sometimes, like today, it’s both.
Notwithstanding what it may feel like, the evidence is clear: over long periods of time, the rewards of investing in the stock market massively outweigh the risk.
Given the historical context, assuming an 8% return over long periods of time hardly seems aggressive.
You can, and should, form your own view. But whatever you do, please don’t ignore the wonderful money making machine that is the stock market.
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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