Stock Market Assumption Rate of Return Question

[genchan]

When trying to calculate out my retirement what rate of return for index stock funds do you use and why? Dave Ramsey assumes a 12% return when callers ask as well as in his books. Is this a bit overoptimistic? Would a lower rate of 8% be more realistic with today's stock market? What assumptions do you use when doing your calculations?

[Broken Arrow]

I use 8%. I think 12% is a bit optimistic.

I could be wrong, but I think it's better to be err on the side of caution.

[simpletron]

I use real rate of return(rate of return minus inflation and expenses) of 5%(conserative), 6%(normal), 7%(optimtistic). I dont think about in absolute terms because if inflation is run amok at 12% and your stock market returns at 14%, then it was a bad year because I only gained 2% purchasing power even though it would be a great year to both of you and dave.

the reason why 5%, 6%, or 7% is because the very long term history(90+ years) of the stock market is 10-11% and inflation is 3-4%. the average expense ratio of my mutual funds is .5%, so in the conserative case(low return, high inflation) my real return is 10-4-.5=5.5%. in the optimtistic case, it is 11-3-.5=7.5%. I rounded down because I rather oversave that not have enough.

I make sure that I am saving at the normal rate with a goal to save at the conserative rate. but I like seeing the optimtistic case just to see what could happen.

[disneysteve]

7-8% is a safe number for planning. 12% is ridiculous. There are funds that have racked up 12% or higher returns over the long run, but they are rare. A well-diversified portfolio will likely return 8% or so.

[jIM_Ohio]

I would run both 8% and 12% through the same calculators and look at the difference it makes. If you can get 12% returns for an extended period of time (5-10 years) you will see a huge difference in either retiring earlier than expected or retiring with more than expected.

I use 9% in my calculations. If I used index funds, I would be using 8%.

[bigsaver]

I wish I could get 12%. I would be able to retire 10 years sooner.

[meaghanchan]

I use 4.5% real return (after inflation). I've read many arguments for future returns not being as high as past returns. William Bernstein makes a good point in "The Intelligent Asset Allocator", that since dividends are much lower than they've been historically (I think they're around 2% now, have historically averaged 3-4% if I'm remembering correctly) and growth has averaged about 2% after inflation, that 4% real is much more realistic than 7, 8, 9% real.

Of course, I'm hoping that my returns would be higher, but I think it's better to err on the side of caution. It's easier to dial back on the savings rate at 55, or to retire early if one wishes, than to play catch up because your returns have not been as high as expected.

(Many others, other than Bernstein, have made similar arguments using a variety of formulas- Bernstein's just the one I've reread most recently).

[ThriftoRama]

I do 4 percent. I hate when articles and such use high assumptions. It's just not realistic, frankly. Better to estimate returns low and be surprised when they are higher, than to base everything on a number that may never happen, then end up short.

[disneysteve]

I do 4 percent. I hate when articles and such use high assumptions. It's just not realistic, frankly.

While it may be true that it is safer to assume 4%, if I actually only earned 4% on my portfolio, I'd never be able to retire. And if you are, in fact, only earning 4%, you are doing a lousy job investing. There is no reason why a long-term portfolio shouldn't be able to return 7-8% at least over time.

[jIM_Ohio]

Do not take investment advice from Dave Ramsey. Period.

When I do return calculations I aways do at least two and usually 3 runs.

The two runs are 8% and 11%. I will often do a third at 6%.

6% is worst case- I could do a 40-60 asset allocation and get 6% without much risk. If 4-5 year periods for my allocation do not return above 6%, I will immediately go more conservative to get 6%.

8% can be achieved with less risk than the overall market- equity income funds for example.

11% can be achieved. This requires discipline and the ability to invest cash into down markets. If you want 11% and are not "all in" right now, then don't use 11% for any planning.

Obviously the question posed is about TOTAL return (principal increase and dividends paid).

I try to get 3.5% on the dividend return and if this is achieved, I would argue total return is close to an irrelevant calculation. Not totally irrelevant, but a person can probably live off the 3.5 yield if they invested well and spent wisely.

[jc3900]

After running a multitude of scenarios as far as investment planning goes, I have learned one thing. That is there are four keys that make up any investment: Principal Investment Amount($), Time of Investment, Diversification of Investments, and Investment Return. Three out of the four mentioned you yourself can directly and indirectly control. My advice would be to save as much as you can, as early as you can, and as diversified as you can. Then just let the chips fall as the may. Focus especially on the factors that you can influence and you will come out great.

PS: I am still addicted to financial calculators.

[noppenbd]

I use 9% in my calculations. If I used index funds, I would be using 8%.

I'm sorry, but this statement bugs me. Please back this up with some data. Everything I have read (Bernstein, Malkiel, Swensen, Burns) says that 60-80% (depending on time period) of managed funds fail to beat their respective index, and that the best predictor of future performance is expenses. Unless you are only going to invest in the top 20-30% of managed funds you are better off in index funds with low expense ratios. Of course there is no way of knowing which funds will be in the top 20-30% in the future.

[disneysteve]

I use 9% in my calculations. If I used index funds, I would be using 8%.

I'm sorry, but this statement bugs me. Please back this up with some data.

I missed that comment, Jim. I'm also curious of your reasoning there. Managed funds typically have higher expense ratios and almost uniformly fail to match the market indices over the long run. There are notable exceptions, and with an index fund, you won't ever get a breakout year with stellar returns (I've had managed funds return 70% in a year) but over the long run, everything suggests that the index funds will be the tortoise that wins the race.

[jIM_Ohio]

I missed that comment, Jim. I'm also curious of your reasoning there. Managed funds typically have higher expense ratios and almost uniformly fail to match the market indices over the long run. There are notable exceptions, and with an index fund, you won't ever get a breakout year with stellar returns (I've had managed funds return 70% in a year) but over the long run, everything suggests that the index funds will be the tortoise that wins the race.

Buy low sell high.
And risk.

My whole post was this

I would run both 8% and 12% through the same calculators and look at the difference it makes. If you can get 12% returns for an extended period of time (5-10 years) you will see a huge difference in either retiring earlier than expected or retiring with more than expected.

I use 9% in my calculations. If I used index funds, I would be using 8%.

I have an aggressive allocation for part of my overall portfolio. This aggressive portion is supposed to beat the index. If a person uses managed funds they should be attempting to beat the S&P 500 or wilshire 5000 is my opinion.

The index **should** return 8% over 15-25 year periods.
If a person uses managed funds they should be thinking they can beat that return.
If a person takes less risk than the index, it's possible they will also beat the index because they avoid the big down year an index has once or twice or 3 times every decade. You are pyaing the manager to avoid the big dip almost as much as you pay them for the big gain.

For example my aggressive allocation has be buying financials right now. If buying that sector right now does not beat the S&P 500 over the next 5 years, bad move on my part- so if index returns 9%, I should get 10%, if index returns 14% I should get 15%.

If I could not beat the index, why get aggressive?

[noppenbd]

Jim, if by "index funds" you mean only S&P500 index funds, then maybe I could see your point. However, there are so many index funds out there now (small cap, international, emerging markets) that saying that using index funds is not aggressive is just not true.

And just because someone is thinking they can beat the return of an index doesn't mean they will. Of course the managed funds will tell you they can beat the index every year, otherwise they wouldn't be able to get any investors!