A Magic Money Making Machine

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?

Is the expected return on stocks high enough to compensate for the stomach-churning ride, or are you better off having a chunk of your money in bonds?

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.

A 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:

S&P 500 Returns By Year

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.

S&P 500 one-time investment

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.

…And Consistency

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.

Annual investment in the S&P 500

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:

Recent S&P 500 performance

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.

S&P returns since 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?

Who knows?

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.

Happy investing!

About Banker On Fire

Enjoyed this post?

Then you may want to sign up for our exclusive updates, delivered straight to your inbox.

You can also follow me on Twitter or Facebook, or share the post using the buttons above.

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.

Find out more about me and this blog here.

If you are new to investing, here is a good place to start.

For advertising opportunities, please send an email to bankeronfire at gmail dot com

14 thoughts on “A Magic Money Making Machine”

  1. Morning BoF!

    Nice to have you back twice a week!

    I also see this debate a lot but tend to agree the data just is what it is – how you use it and what you think you are happy to assume personally risk-wise going forwards is as much, if not more, important to understand if you then choose to use something different for planning purposes.

    The one aspect that does sometimes concern me is when I see people applying these pretty well-known S&P data assumptions across their entire FIRE planning. I saw the same issue back when working in energy trading – the quants would use the “best” data set available, i.e. lots of clean history – which wouldn’t necessarily actually be the most relevant to the problem being modelled. Again, it just really comes down to understanding your modelling assumptions & how you will deal with any change.

    Maybe I’m just in a different place on this, wouldn’t be the first time. But I don’t have my investments 100% in the S&P, not even 100% in the US stock markets. So it makes no sense whatsoever to me to use the S&P based numbers when I know a lot of my investments don’t have that same risk/return profile. So personally I use a blended rate across all the different types I have.

    Yes it’s lower & so I had to accept the trade-off that meant in terms of extra years of saving/investing before retiring two years ago at 43. And I get perhaps it’s easier for people to start if they feel the end-game is more within reach.

    Anyway – enough rambling – cheers for writing about an oft mis-quoted subject!


    1. Thanks Michelle.

      You are right – no sense applying a blanket return assumption to a portfolio consisting of cash/bonds/world equities. Another aspect most people seem to ignore is the fact that your asset allocation becomes more conservative over time, and so the returns decline commensurately.

      US investors do have an advantage here, though the reality is that even in a world tracker, you will likely hold 50%+ US equities.

      If you don’t mind me asking, how do you go about setting a return assumption for your international equity holdings?

      1. The scatter graph of S&P returns over the last c.100 years reminds me of our four year old twin boys’ aim now that they stand up to pee.

        Whilst I’m happy to accept the volatility of the S&P in exchange for the additional return, I really just want zero volatility when it comes to the aim of my sons!

      2. Hey BoF

        Unsurprisingly I agree on the aging/conservative front too. A lot of people forget to account for that.

        To be honest – I haven’t done that leg-work although it would be interesting. I work backwards instead & use a 3% rate with plenty of contingency in the budget assumptions. So risk/reward profile is highly skewed towards upside only.

        Yeah, I may well have worked a couple more years than needed but the peace of mind, especially now, was worth it to us. Like you, I was pretty much a one out, tough to get back in at same pay/benefits.

        Now what would be really interesting would be to see the different indices compared on both a return & risk basis. Wonder how S&P would fare then – somebody must have done that already surely??!

        1. Makes sense. I use a 4% rate but I also have lots of slack in my budget assumptions. In addition, I’m not nearly ready to leave work yet, so I focus on growing our net worth and taking things from there.

          I’d love to see a comparison of international / european / US returns as well. Problem I always run into is the data set for international equities only goes back 30 odd years or so. Hardly enough to inform an educated opinion.

  2. Pingback: The Full English Accompaniment – The Lost Year – The FIRE Shrink

  3. Pingback: Best Blog Posts - Q32020 - Bella Wanana

  4. Hi Banker,

    Thanks for this article. Some very interesting graphs you show here!

    Quick question about the last two graphs. Do they consider a lump-sum investment in year 1 or annual investments (i.e. annual DCA) for the respective periods on both graphs?

    By “annualized return” you mean CAGR right?

    Thx & Happy holidays!

    1. Cheers John. The math assumes an investment on day 1 of each year and continuing for the respective time period (i.e. 10 / 20 / 30 or 40 years), then stopping.

      For the returns, I use the IRR formula (as you have cash outflows every year). Using a CAGR wouldn’t capture the time value of money appropriately.

  5. Thanks for the great article.

    I would like to have two quick questions:
    1. From the statistics you show above, I think it’s pretty clear that assuming 10% is not aggressive. Still, why do you choose to go with 8%?

    2. Does that mean that your expectation of long-term real return is 8 – 3% (inflation) = 5% ?


    1. Thanks Adam.

      On #1, it’s pure conservatism. I’d rather be surprised on the upside than on the downside. In addition, the data above is for the US market. World equities (which most folks in the FIRE community are encouraged to hold) have lagged the US to the tune of 1 – 1.5% per year

      On #2, that’s right.

  6. Pingback: Stretch goal: Invest 100K in index funds by end of year – Money Savvy Ladies

  7. Pingback: 20 Personal Finance Charts To Help You Build Wealth In 2022 - Physician on FIRE

Leave a Reply