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Estimating Stock Returns When Using Financial Planning Software

It’s a very risky thing to try to “beat the market” and doing so likely makes you more of a gambler than an investor.  That said, if you want to craft a sound financial plan or retirement plan, even using personal financial planning software like FinanSavvy that handles the forecasting for you, you need to have some idea of what kind of average annual returns to expect over time from “The Market”.  The Market can be defined in practice as any sufficiently diversified portfolio of stocks.  We like 4% + inflation (4% “real returns”) before taxes for 5-10+ year investment periods, here’s why.

budgets, retirement planner and personal finance blog
Statistics don't lie, but liars love statistics.

Things to Consider When Looking Into This

You’d think this would be easy considering that all of this data has been tracked carefully since the beginning of it all.  Nonetheless some factors can confound even a motivated seeker of knowledge armed with the power of Google trying to answer this question by looking at the historical return rates of various investment options.

Like any distillation of vast quantities of data, in each case there are interpretations and assumptions made by the analyst or retirement planning calculator developer or whomever is doing the work.  Given that most summary information presented to us is formulated by organizations that sell investment products, you can usually assume that the time frames and assumptions used in the calculations are those that provide the most favorable results.  Some important considerations:

Time Frame:  Someone calculating the return of the market or a fund is required to specify the period of time for the returns calculated.  They are also generally free to choose the period that they want to use.  Given this, a savvy marketeer may choose shorter periods (e.g. last 3 or 5 years) when markets have recently performed well, longer periods when they have not (e.g. 10 or 20 years).

Expenses:  All mutual funds have expense ratios.  They can range from 0.1% for a low cost index fund to 3% or more for an expensive actively managed fund.  Whether a fund’s historical returns are reported before or after expenses can have a very significant effect on the result.

Tax Impact:  This is especially true of stocks, because if you buy and hold a stock and it appreciates in value, you don’t pay any taxes until you sell it and if you hold it long enough the tax rate is lower than normal income.  It is important to understand then that if a fund comprised of some number of stocks is constantly being changed while attaining some rate of return, you can end up paying a lot more in taxes than on a fund that is changed more rarely and achieving the same returns.

Inflation:  While inflation mainly effects your Budgets and expected spending over time, market returns tend to vary with inflation as well, rising to account for higher inflation and dropping during periods of lower inflation (though not always by the same amount as inflation is typically bad for many businesses such as retail, while helping others such as commodity producers).  However in practice what matters to you, the holder of a diverse portfolio, is “real return” or return after inflation.  So the question you need to answer is “what returns should I expect above and beyond inflation”.  Earning a 12% return on stocks is considerably better (and not sustainable) when inflation is a low 2% than when it was a high 8%.  This effect is so important for example that if you had bought the market at any time in the 1960s and held it all the way until 2013, your average annual real return before taxes would be 4%.  That’s a much more meaningful piece of information than the 8% average nominal pre-tax return rate for the entire history of the market so often quoted.

Why We Think 4% Real Return Makes Sense

Fortunately one analyst firm we have found has done us all the service of creating a comprehensive market history matrix.  Crestmont Research has made matrices that show annualized returns including dividends after inflation and other expenses but without accounting for taxes (which are impacted more by trading behavior more than any other factor) for any period of time you want to see on their site.  Using this data we concluded that the overall real (after inflation) rate of return for the stock market that it makes sense to assume over a 10+ year period ranges from 3-5%, making 4% real return is a good conservative long term estimate for planning purposes.  So for example if you think inflation will average 3%, you’d use 7% for your equities portfolio.

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