It never ceases to amaze me when I hear people mentioning how they think stocks will return 12% a year when discussing long-term planning. My guess is that most of this comes from Dave Ramsey and his acolytes, but they are not the only ones who I have heard put this information out into the world.
The problem of course, is that expecting this type of return is extremely dangerous to your long-term financial plans.
(Full Disclosure: I think Dave Ramsey does great work for people who have troubles with solving debt issues, budgeting, etc. This however is a dangerous assumption to be telling people)
First and foremost, the way it gets explained by most people shows a clear misunderstanding of investing returns. Here is an example from the article linked to above:
The current average annual return from 1926, the year of the S&P’s inception, through 2011 is 11.69%.
Did you catch it?? “Average Annual Return”…
Of course, our money does not grow at the average annual return rate, it grows at the compounded annual growth rate. So, what is the big deal right? There couldn’t be that big of a difference…
From 1928-2016 the SP 500 had an average annual return (Remember our money does not grow at this rate) of 11.42%. The compounded annual growth rate (Which our money does grow at) was 9.52%. Now 2% between friends may not seem to be that big of deal, but when it comes to long-term planning, it can be a huge deal.
(Side note: I love how the Ramsey article just gives themselves an extra 0.31% in returns to get to 12%. I wish investing was that simple)
Now you could get lucky. Looking back to 1928, there were some 30-year periods that compounded at 12% or more. Once again though, you are rolling the dice with poor odds. These types of returns happened in only 23% of all 30-year periods. That is not a chance I want to take.
Now lets say you decided that your goal is to have $1 million dollars in 30 years. Below is a table showing how much you need to save every year, for 30 years, depending on the growth rate. I included the Ramsey Special (12%), the SP 500 average annual returns from 1928-2016 (11.42%), the SP 500 compounded annual growth rate from 1928-2016 (9.52%), the diversified mix of 70% stocks and 30% bonds (7.5%).
Year 1 shows the amounts someone would need to save every year given the level of return each scenario achieved. Now here is the issue:
What if you saved $4,200 a year based on an expected 12% return, but only earned a more realistic 7.5%? Well, instead of $1 million, you would have $434,277.49… That would throw quite a wrench into your plans.
Now lets say you expected 7.5% and saved $10,000 a year but actually earned 9.52%? Well, instead of $1 million, you would have $1,502,513.96… Things could be worse.
The main problem with such lofty return expectations is that the risk of outliving our money is much higher than the risk (or regret) of over-saving.
I understand that there is a balance we want to achieve in this dilemma and that people do not want to penny-pinch their whole lives, but missing out on a couple vacations throughout your lifetime to make sure that you don’t go on food-stamps at age 90 is a reasonable trade-off. Leaning a bit conservative when using return expectations in ones life is not only prudent in my opinion, but it will also help with the stress and anxiety of reaching financial goals in a reasonable amount of time.
Have some fun out there!