Planning investment rates

[LivingAlmostLarge]

What interest rate on your investments do you use when you plan? Do you use 8%? 6% How long? Do you scale down as it gets shorter term? I am wondering because it makes a big difference when planning for retirement when I play with the calculators using 8% versus say 6% or 4%.

[kork13]

It depends on how I'm investing it (which does correlate to timeline). I use numbers "beyond inflation" (+i), on the presumption that my objective is to grow my assets faster than inflation devalues them. It also makes the numbers simpler to comprehend, by keeping everything in "today's dollars."

I normally use anything from 0%-7% beyond inflation for my planning purposes. Different investment types are at different places along that spectrum. In my mind, I normally use these figures:
0%+i: Savings accounts/CDs (although even this isn't true today)
1%+i: Real estate
2-3%+i: Bonds
4-5%+i: Average for a weighted 70/30 portfolio
6-7%+i: Stocks

As you can probably tell, I normally use 4-5% above inflation for most of my long-term planning projections. Assuming inflation remains between 1.5%-3.5%, I see that as a reasonable (if not slightly conservative) average return over the long term.

The longer your projection runs (5 years vs. 40 years), the more exaggerated the effect will be from your chosen rate of return. $10k invested with a projected 4% return for 5 years: ~$12k. Use a 6% RoR: ~$13k. But use those different RoR's on $10k invested for 40 years... 4%: $48k, 6%: $103k. As we all know, compounding matters.

[BuckyBadger]

I use 3% above inflation. So I just use "today" dollars for all my calculations and use 3% as total investment return.

[humandraydel]

I also do "inflation adjusted" returns - I use 5% after inflation.

[feh]

What interest rate on your investments do you use when you plan? Do you use 8%? 6% How long? Do you scale down as it gets shorter term? I am wondering because it makes a big difference when planning for retirement when I play with the calculators using 8% versus say 6% or 4%.

I use historical averages, and then adjust them to the best of my ability. For historical numbers, I tend to use:

• 9% equities
• 5% intermediate term bonds
• 3% inflation

Looking at PE10 right now and the very low returns on bonds, the numbers I currently use are:

• 6.5% equities
• 3% intermediate term bonds
• 2% inflation

You'll have to plug in your own numbers regarding the equities/fixed income split in your portfolio. For me, these numbers indicate about 3% real return.

Running out of money in retirement would be bad, so I try to be conservative. Instead of the standard 4% withdrawal rate, I'm planning on something around 3.3%.

[LivingAlmostLarge]

What happens when do have bad years?

[feh]

What happens when do have bad years?

Continue to contribute. Rebalance if necessary.

[disneysteve]

What happens when do have bad years?

Nothing. The projections are based on average annual returns. If you plan with 6% or 8% or whatever number you like, it is understood that you won't achieve exactly that every year. Some years will be higher, some years lower. Year to date, I have funds that are up as much as 40%. I don't expect that to continue but it helps balance the years that are only up 3 or 4% or even down a few points.

[kork13]

Nothing. The projections are based on average annual returns. If you plan with 6% or 8% or whatever number you like, it is understood that you won't achieve exactly that every year. Some years will be higher, some years lower. Year to date, I have funds that are up as much as 40%. I don't expect that to continue but it helps balance the years that are only up 3 or 4% or even down a few points.

Exactly. Because in the end, the term "projection" is merely a nice way of saying "I'm gonna make a wild **ahem** guess here, and plan my entire future off of it." Use a figure that you think is a reasonable average. Use it as a general guide to lay down some guide posts along the road.... while understanding that it's really little more than a guess, so we do what we can.

[disneysteve]

"projection" is merely a nice way of saying [I]"I'm gonna make a wild **ahem** guess

it's really little more than a guess

I don't think it is just a guess. Assuming you are investing in things that have a good long track record, history is important. I know that "past returns are no guarantee of future results" but still, the history matters.

One of our biggest holdings is an S&P 500 index fund. The fund has existed since 1976 and has an average annual return since that time of 10.93%. It isn't unreasonable to expect that if that's what it did over the past 40 years, it will do something generally similar over the next 40. Still, I wouldn't use 11% in my planning just to be safe but I think using 7 or 8% is quite reasonable and has a firm basis in reality, not just a wild guess.

On the other hand, if you are buying speculative stuff or trading individual stocks, it may be a lot more of a guess to estimate future returns.

[feh]

On the other hand, if you are buying speculative stuff or trading individual stocks, it may be a lot more of a guess to estimate future returns.

Steve makes an important point here. My numbers are based on indices, because those are the kind of funds I invest in. If your portfolio is a bunch of commodities, hedge funds, individual stocks, etc, then all bets are off.

[jIM_Ohio]

There are 4 things which influence investment outcomes:

1) Savings rate, which the investor controls
2) Asset Allocation and rebalancing, which the investor controls
3) Inflation, which the investor does not control
4) the returns of the investments in the portfolio, which the investor does not control

Savings rate is the highest impact- to have higher success, save more
Inflation is the next highest impact, and an investor has little control over this.

There is also an investment phenomenon called sequence of returns. A person could have been getting their average return they predicted from 1978-2007. Then 2008 comes along and wipes out about 25-40% of porfolio. The average return may have not changed, but the account balance just did.

When playing with calculators, focus on the 4 variables a person can control, and then check a variable (like investment returns) and see if 4% and 8% work, and what the differences are. Often times people pick a year to retire, then want to see the average return they need with a 10% savings rate to get there (or insert desired savings rate). Then they take on risk based on that line of thinking. I believe that is bass ackwards, because the higher risk might trigger other negative behavior (like rebalancing at wrong time, pulling out, or something like that). If a person focuses on their risks, and adjusts spending and savings rate accordingly, the probability for success is much higher.

In addition, consider that a 9% average return comes with a 16% deviation. Meaning -7% and +25% are equally likely outcomes and the -7% contributes to the 9% historical average, and a year with 25% returns is actually an "average" return, not a "better than average" return.

I would focus more on the deviations than the linear average returns. Inflation is like this- many years of 1-2% inflation, then a couple years with 10-11% inflation type inputs to generate that 3% historical average.

[kork13]

I don't think it is just a guess. Assuming you are investing in things that have a good long track record, history is important. I know that "past returns are no guarantee of future results" but still, the history matters.

One of our biggest holdings is an S&P 500 index fund. The fund has existed since 1976 and has an average annual return since that time of 10.93%. It isn't unreasonable to expect that if that's what it did over the past 40 years, it will do something generally similar over the next 40. Still, I wouldn't use 11% in my planning just to be safe but I think using 7 or 8% is quite reasonable and has a firm basis in reality, not just a wild guess.

On the other hand, if you are buying speculative stuff or trading individual stocks, it may be a lot more of a guess to estimate future returns.

Valid, perhaps I over-simplified there... My point is that because we obviously can't know what our investments will return over the long term, we should only use these kind of projections as a rough planning tool... Not a window into the future. Furthermore, it's not terribly important whether you decide to use 3% vs. 4% or whatever... A 1-2% difference (or inaccuracy) is significant, but won't mean the difference between wealth and poverty. As long as the ROR is reasonable, it will do its job.... It'll give you a basic idea of what you're looking at down the road, allow you to formulate some goals and courses of action, and implement those plans with a reasonable probability of success. Over time, continued use of additional projections allow you to hone your plan & adjust as required.

[disneysteve]

it's not terribly important whether you decide to use 3% vs. 4% or whatever... A 1-2% difference (or inaccuracy) is significant, but won't mean the difference between wealth and poverty.

Savings rate is the highest impact- to have higher success, save more

I think Jim makes an important point. There is a reason why we all recommend saving 15% of income for retirement. If you do that, the investment return isn't quite as important. You will have amassed a sufficient amount of money to have a decent lifestyle whether you earn 6% or 8% or 10%. Obviously you'll be able to live a little better on 10% than on 6% but you will be just fine either way because you will have saved enough.

[LivingAlmostLarge]

It's pretty painful though to see the differential of ROI rates on our savings. It makes a difference between feeling you're saving enough and not enough. I've been pretty conservative estimating 5-6%.