Dude, where’s my 7% Investment Return?
In most of my examples of small savings adding up over time, I assume that you the saver are not only saving the money, but investing it for some compounding gains. For example, I once stated that saving $25 per week by skipping a restaurant meal adds up to about $19200 after 10 years. To get numbers like that, I’m assuming that someone is investing the $25 each week into an imaginary investment that goes up in value a little bit each month, for a total gain of 7% per year. Without this compounding, the $25 per week would still add up to a big number.. but it would be $13,000 instead of $19,200.
Is this realistic? Many people have questioned my optimism. And others have questioned my pessimism: Dave Ramsey always repeats the phrase that “the stock market average return has been 12% for the past 70 years, so why am I using 7%?
To the credit of the pessimists, it is true that a person investing a monthly series of payments into US stocks over the ten years leading up to right now, June 6th, 2011 would have only yielded 2.3% per year compounded. After adjusting for inflation, it’s even worse: the investment is worth less than 1% more than it was ten years ago.
Why did this happen? To find out, let’s look at a chart of the S&P 500 index over the super-volatile last ten years:
As you can see, the stock index is now very close to where it was ten years ago. The only thing that provided even the tiny 2.3% annual return I mentioned was the quarterly dividends you would have received (adding just under 2% per year), and a small benefit from dollar-cost averaging (by buying, say, $1000 per month of shares, you would automatically end up buying more during the months stocks were in the bargain bin, like in 2002 and 2008).
So with the stock market being so volatile, how can we be expected to use it as a short-time retirement planner?
Unfortunately, I cannot offer any guarantees. But I can offer an interesting example of how statistically unlikely this is to happen in any given 10-year period, loosely paraphrased from a stock market book I happen to be reading right now.
Imagine you could fly freely back and forth to any year between 1950 and today. And you could test out the stock market returns for all possible periods in that range. For example: measure the return for a one-year period beginning in January 1950, ending in January 1951. Then measure from February 1950 to February 1951. And so on, through all the many hundreds of possible hypothetical 1-year investments.
Then repeat this whole test for all possible 5-year holding periods. And 10-year periods. And 15, 20, and 25-year periods.
If you use a time machine, or even just a regular computer to do all of these tests, you get some pretty neat results. Check out how quickly the stock market volatility smooths out over time:
1-year holding periods: Worst: -37% (and it was in 2008!) Best: +52.62%
5-year periods: Worst: -2.35% Best: +28.55%
10-year periods: Worst: -1.38% Best: +19.35%
15-year periods: Worst: +4.31% Best: +18.93%
20-year periods: Worst: +6.53% Best: 17.87%
25-year periods: Worst: +7.94% Best: +17.24%
The average for all periods is of course the average annualized stock market return for the overall period, which is about 11.1%
After adjusting for inflation, this 11.1% annualized number would become 7.16% over the 1950-2011 period. (Inflation was very high during the 1980s, so it averages to 4% in this example instead of the 2-3% currently forecast for our own future).
So what do you do if you happen to hit the wrong 10-year period and your savings don’t grow as expected? Having done much of my own retirement saving during the past decade, I’m in this boat myself.
The solution I like to use is to just remain flexible. I did end up working longer than originally planned because of the stock market fluctuations, and during lean years of the stock market, I decided to spend less rather than withdrawing savings right after the stock market crash of 2008. I also like the idea of keeping a local rental house as part of my portfolio, and always leaving the door open for any amount of part-time work that might be needed.
There are also less risky investments that you can make – mixing stocks with bonds or other more stable (but on average lower return) investments is very standard advice for people as they get closer to retirement age. Those mixtures deserve their own articles for the unique situation of a Mustachian Investor, since some of us might be just making their first investment deposit as a new graduate, and yet still be less than 10 years from retirement!
But meanwhile, at least we can say this: If you plan for a retirement income that is pretty cushy, say $40,000 per year for a small-to-medium family, you have plenty of fat that can be trimmed in the event of down markets.
On average, if the stock market continues its historical performance, your investments will return close to 7% per year even after keeping up with inflation. But to get the full benefit of this 7%, you would need to time your spending strategically: reduce spending if you hit some bad stock market years early on in your retirement. Then you can crank it back up during future booms.
If this sounds too complicated, you can of course just work for an extra year and build the portfolio even more. But being a man who thinks flexibility and early retirement are all part of the same package, I prefer to take on a little more risk in exchange for more free time earlier in life. Even during one of the worst 10-year periods in stock market history, I have to report: so far, so good.
There is obviously much more to say on the topic of stock investing. I’ve been reading more books than usual on the topic recently, in an attempt to answer various unexpected questions that people have been sending in to MMM headquarters. It has been quite valuable to me to hear so about the situations of many other people. The questions have forced me to learn more for my own benefit as well. And all of it has inspired a whole series of stock market articles, so let the Investing Series begin!
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