The idea of stock investments doubling in value every seven years or so is based on an estimated historic average annual total returns of 9% to 10%. If Jack Bogle, founder of the Vanguard Group, is right future returns are much more likely to be in the vicinity of 1% to 2%:
“People ought to be very conscious of the mathematics of investing,” Bogle, who now runs Vanguard’s Bogle Financial Markets Research Center, said in a recent interview. “But they so often ignore it.”
He acknowledges that his 1 percent to 2 percent return calculation isn’t a hard rule, because it’s based on many of the variables affecting market performance. But it’s instructive for understanding why an investor’s net returns pale in comparison to market returns.
Here’s how he figures it. Assume a nominal rate of return for the foreseeable of future of around 7%. Inflation eats two points, taxes, another point, and management fees another two points. That leaves 2%. The “Rule of 72” tells us that at that rate it would take roughly 36 years to double your money, a far cry from 7.
What if he’s right? For me that raises a couple of questions. First, does that put a premium on good management or put downwards pressure on management fees? Probably both. In this regard it’s interesting to note that the SEC appears to have come around to the view that if your fund’s performance is significantly better than others’, you’re probably cheating.
I also suspect that professional money managers will receive significantly more scrutiny under a regime of very low returns than they would under one of high returns. Nobody much cares as long as their capital is increasing rapidly. If it’s increasing slowly, not increasing at all, or even decreasing, won’t they be inclined to put everything under a microscope?
Additrionally, wouldn’t expected performance like that put a bit of a damper on the various plans to privatize Social Security? Social Security’s “rate of return” is in about that range. If you assume that the rate of returns for a fully privatized system are normal and have an average of 2% with a standard deviation of one point my back of the envelope calculation tells me that about three-quarters of the population would see returns below 4% and a quarter would see capital losses.
“Additrionally, wouldn’t expected performance like that put a bit of a damper on the various plans to privatize Social Security”
I was going to say.
“If you assume that the rate of returns for a fully privatized system are normal and have an average of 2% with a standard deviation of one point my back of the envelope calculation tells me that about three-quarters of the population would see returns below 4% and a quarter would see capital losses.”
And aren’t there the effects of crashes, downturns, etc.? Not out of the question that folks, over the years of their employment, would find themselves “starting over” more than a few times. And if one of those times just coincides with your retirement….
Or management may opt to take on more risk in search of higher returns.
Personally, the 7-10% a year rise in the stock market is another one of those mantras I no longer take for granted. It’s a major reason why I’m going back to work full-time once we’re in Florida even though I don’t need to. We’ll be saving almost everything I make (after employment expenses, of course). We’re at the age where we really have to seriously consider our financial futures. That future doesn’t look good for my generation. Social security benefits will probably be lower than what they are today. Medical care will certainly be much more expensive no matter who is writing the checks. Real estate as a nest egg doesn’t look too promising. 401k’s and the stock market will likely perform below historical trends. What else is there? The only way to make up for paltry returns is to save more up front and that’s exactly what we intend to do. Work our assess off, hedge as much as possible and hope for the best.
Everytime I read one of Icepick’s comments, I can’t help but think – “there, but for the grace of God…” – and I’m agnostic.
“Personally, the 7-10% a year rise in the stock market is another one of those mantras I no longer take for granted. ”
I’ve got a friend who refuses to accept that, and has continued shoveling money into equities since 2008 despite massive losses. He’s convinced the market will somehow turn around and start rapidly adding valuation no matter what he’s told about the dynamics. I think there are a lot of armchair investors out there who’ll never stop looking for the next chance to get rich quick; as long as they exist, there will be money managers out to make a buck from their greed and ignorance.
Ben,
Most of our long-term savings are still in equities and we still have money going into those vehicles each month. Frankly I don’t know where else to put it at this point – that’s something I need to do a lot more research on.
Another thing to consider are pensions, particularly for government employees. Many are underfunded even assuming a 7-10% ROI.
Australian banks are paying 5-6% on short term deposits.
I asked John Quiggin why that is and he said it’s because the Australian central bank charges a fairly high interest rate to member banks, unlike America’s, which has set its rate to zero.
So if you can put your money into Australian banks somehow…
@Andy
For now you’d be better off putting your money in treasuries and cash. Pay attention to the Fed: they’ll send out subtle messages warning when they’ll raise interest rates, and that’s when you sell and get ready to jump back into equities.
ponce,
Another reason to love Australia!
Ben,
Thanks, I’ll look into it. Reevaluating finances is a major project for the new year.
Where have you gone, Bernie Madoff?
A nation turns its lonely eyes to you . . .
(Woo woo woo)
What’s that you say, Mrs. Robinson
A guaranteed rate of return has gone away?
(Hey Hey Hey)
The numbers from the article do not make any sense to me.
Stocks have historically averaged 9-10% gains, but he predicts 7% gains for the next several years. He then subtracts 5-6% from the 7%, but he does not subtract those from the historic average. Is the actual historic 5-6% higher?
His lost decade could be disputed depending upon the start/end date. Stock market bulls would use an end date later than 2009. To be clear, I personally would not make this argument. I do agree with the observation that some people were devastated by the stock market.
“For the Snark was a Boojum, you see.”
@Ben Wolf
I would argue that when the Fed raises the interest rates, stocks will drop. The Financial industry is making money by borrowing 0% and lending at 3%. Once the spigot is turned off, their profits will drop.
I believe there is a stock market bubble. The market is at pre-2008 levels. I find it hard to believe the economy is as good as it appeared before the financial crisis. I contend that some of the money being created is flowing into the stock market. If this were a closed system, I would expect stock prices to drop when the interest rates go up, but …
Depending upon conditions elsewhere, the stock market could rise, and US bonds could decrease. The US is considered the least crappy of all the crappy places to invest. The US crediting rating can drop as low as possible, but the US will pay off its debts. Our creditors will never take a “haircut” on our debt, and that makes our rating AAA+++ regardless of the Rating Agencies.
My advice would be to do as much research as possible. If investing in a managed fund, learn about the manager, and especially, how he did during the financial crisis. Anybody who could not see the housing bust and subsequent crisis will not see the next one. Unfortunately, most of these clowns are still there.
“For the Snark was a Boojum, you see.”
@Tastybits
“I would argue that when the Fed raises the interest rates, stocks will drop. The Financial industry is making money by borrowing 0% and lending at 3%.”
The cost of borrowing via the discount window is separate from treasuries yields, and is called the Fed Funds rate. It’s quite possible the Fed could at some point raise interest rates on treasuries while maintaining the FF rate at near 0%, meaning banks would grab an even greater return.
When you buy a treasury the yield is locked in at whatever it was when you made the purchase. So if the Fed raises interest rates on new bond issuances the resale value of your T-bills will fall because the new bonds will have a higher yield, and therefore would have a greater value than your old bonds. The good news is the Fed subtly announces such changes well ahead of time so long as one pays attention.
If I recall correctly the 2% SS return is a gross, not net return. So we have an apples to orange comparison. Its unclear to me how to attribute inflation and deferred taxes to SS.
In any event if we continue to follow the various tax, regulatory environmental etc policies we are now, its not a stretch to think equity returns might fall below their long term average. Those numbers Ibbotson puts out aren’t declared by divine intervention.
“I also suspect that professional money managers will receive significantly more scrutiny…..” I think this is correct. it is being experienced in private equity as we speak.
A full treatment of this subject requires us to have a discussion about risk adjusted returns. A lengthy topic. Aspects that would need to be developed would include investment alternatives, resultant capital flight to other countries, yield chase etc.
The ultimate argument in favor of saving social security in the form of government bonds is not their performance but their security. Any other investment vehicle is necessarily of significantly higher risk to the principal.
Be careful with currency translation risk, ponce.