Ask almost any financial advisor what investors should expect to earn from their stock market investments, on average, and you are apt to hear 10.32 percent. There’s an Ibbotson chart on the wall of most brokerage forms illustrating the substantial outperformance of equities over cash, bonds and inflation since the dawn of time (well, not literally, but usually back to 1925). This chart illustrates a well understood maxim of finance—the best place for money over the really long term is stocks.
I do not necessarily dispute this widely held belief, nor would I attempt to argue in this missive that there is some other asset class destined to outperform equities in the long term. I will assert, however, that those who hold to “10 percent over the long term” as bible are destined to fall victim to it. While it’s certainly educational to look back over 90 years of data, it’s also enlightening to further dissect the data.
If there is one thing true about the world, it’s that it is constantly evolving. If nothing else, everyone should be able to agree that 2016 is quite different from 1916—or 1950 or 1974, for that matter—not just in terms of hairstyles or technological improvements, but in the interconnectedness of the global economy. These changes, which are natural, have ramifications (ripple effects, if you will) throughout all the world’s economic activity, including the financial markets. Accordingly, perhaps incorporating 1927’s or 1963’s equity market performance is not necessarily helpful when contemplating forward-looking projections. How much of the U.S., much less the planet, had access to an automobile in 1930? How does that world compare to the one we live in now, where your smartphone has more computing power than the Apollo spacecraft?
In examining the S&P 500 over the past 30 years, one might be surprised to understand what returns have actually been. The average annual rate of return of the index over the past 30 years has been only 7.45 percent. That’s a far cry from 10.32 percent, but actually better than it was during shorter time frames. Should one look back 20 years, to 1996, the S&P 500 has provided investors 5.32%, and it provided only 3.83% over the past 10 years. Before anyone attempts to discard these figures because of the market’s recent sell-off, if we look back 30 years from the most recent closing high of the S&P 500 (May 1986 to May 2015), we find that the average annual return was 7.89 percent.
What this information should help someone understand is that, on average, investors should expect well below the historical rate of return that the industry has been hyping for decades. The world has become very interconnected. Information on most any topic is available instantly in the palm of your hand. The ability to check vendors and suppliers from all over the globe has resulted in margin compression. The increased competition and access to information has made businesses leaner than they were by historical standards. Therefore, lower rates of return should be expected intuitively since there is less misunderstanding or lack of information to exploit. While this rationale may, or may not, be accurate in explaining why the rates of return have subsided over the past three decades, the fact that annualized returns have diminished over time is indeed accurate. One might even argue that, particularly in recent times, low interest rates are explanation enough for diminished equity returns. Students of finance should recall the capital asset pricing model, which says that if the risk-free rate has decreased, so must all other expected rates of return.
This examination of historical returns is not merely to reset investors’ expectations. It has ramifications for the financial planning process. Most people agree that the average U.S. citizen does not save enough, but consider how well behind most investors are in their retirement savings if their 401(k) will grow only 7 percent (or less) when the average broker or planner has incorporated 10 percent into the financial plan. To put it in context, $1 invested at 10 percent for 30 years grows to $17.45, whereas it amounts to only $7.11 at 7 percent over that same time period. That’s a good deal less than half.
To try and make this analogy more intimate, imagine an individual who puts $10,000 per year into his or her 401(k) for 30 years straight. If we assume the return is 10 percent annually year-in and year-out for 30 years, we get a nest egg of approximately $1.635 million. At 7 percent, it’s not even $935,000. At 5 percent withdrawal rates, this equates to a retirement income of $46,750, not the expected $81,750.
Perhaps more frighteningly, it also means running out of money sooner because medical science is at the same time increasing our life spans. That’s a double whammy!
Investors should expect lower returns on equity assets going forward. I do not mean to say based on recent market or political events, but simply going forward. The byproduct of efficiency and technological advancement is almost certainly lower returns on equities—probably forever. The unfortunate reality is that Social Security is not robust, and the shift from defined benefit pension plans to investor-borne responsibility is rather complete.
In lieu of unrealistic outperformance, investors’ only lifeline is to be found in the savings rate. Changing savings means changing the culture, and that is not likely to occur unless one generation witnesses the pain and misfortune of the one before it. That does not bode well for the current generation of young savers.