Expected Returns

Original Article Posted On: March 21st, 2014
Article Last Updated On: January 21st, 2018

Money under the mattress

Where do you keep your money (that’s my bed)

It’s hard to plan for the future if you don’t know what expected return on investment you can assume.  There is a huge difference between thinking you’re going to be averaging a 5% return on your money and a 15% return.  This section will briefly review the average return on investment that the S&P 500 has seen over the last 60+ years.  Various lazy portfolios may be able to get you a better return than the s&p but for now we’ll cover the basics.  Coming off of 2013 you may be under the impression that the S&P goes up 30% a year (i wish).  In fact it is much more moderate; 2013 was an outlier.

 Average Return on the S&P

Moolanomy has done a fantastic post showing that the CAGR (Compound Annual Growth Rate) of the S&P from 1957 to present has been 9.62%.  Right now you may be thinking “but I’ve heard that the S&P returns 12% on average”.  Average is a tricky measure of growth.  It does not account for compounding over time. Therefore 9.62% is a more accurate number to use for forecasting your investment returns.  Other critics will argue that I am cherrypicking my data (why not go back to the beginning of time which happens to be 1870 in S&P terms).  Well, there were a few small events that happened in the early 20th century that i hope shan’t be repeated going forward (we’ll just call them WWI, Great D, and WWII for short).  And to put your mind at ease, the S&P index only hit 500 companies in 1957.

Does this mean you’ll be getting 9.62% per year ad infinitum?  Hell no…  But it gives you some idea where to start. As I mentioned at the start of this, we may even get more.

 

Average Inflation per year

Inflation is just mean to investors.  It’s also the reason why we can’t just leave all our money under the mattress.  Every year if we leave our money alone it’s worth less.  Everyone has had some experience where their parents (or grandparents, boss, whoever) has said “when i was your age, this taco cost a quarter, and it came with a drink”.  Why is that you ask?  Well because our taco’s are 4x better than theirs.  No, but really, it’s because inflation is a byproduct of a good capitalist economy.  A small amount of inflation creates a need to invest your money to hopefully exceed inflation. it helps stimulate the economy.

How much is a small amount of inflation?  Well 3.5% is a conservative number over a very looong time period, or 3.0% is a more realistic number given the inflationary rates of the last 30 years (yes, this is cherrypicking… but if we smell some change in the wind we’ll update these numbers). We’ll use 3.0% here but feel free to follow your own jive.  The graph below actually shows the CAGR for inflation averaged over the last 66 years.  This roughly follows the modern economy after World War 2. But as you can see in the graph below this, within the last 30 years inflation has been even lower.

Break it down for me in a poem

When you feel the need to invest,

there is something you should test.

Make sure that your money’s working,

and minimize inflation’s lurking.

That will help you meet your goals,

and let you take leisurely strolls.

 – Snoop Dogg

 

Let’s get back on track

Once again, these are no guarantee’s.  If anything, I can guarantee you that for the next year the S&P will not go up 9.62% and inflation will not devalue our money by 3.00%.  These numbers are meant to aide you in forecasting your investments.  Over time, you wouldn’t be in bad straights to assume that your money is going to increase by 9.62% and your money is going to lose 3.00% of its value (or net 6.62%).  This also shows that overtime your money is going to increase in value.  So get out from under that mattress and lets get started.

 

Past performance is no guarantee of future results

People love to use this as a “there’s no reason to forecast”.  I get what they’re saying. But using some generalizations to build yourself a sound portfolio isn’t a bad idea.  Feel free to guess some shit.