When it comes to planning for retirement, every plan requires making some key assumptions. One of the most important assumptions is the rate of return you expect to earn on your investment portfolio. From 1926-2016, the stock market has achieved an average return of 10 percent (10.1 percent ).
Most investors would never expect the market will provide a return of 10 percent over a one- or three-year period. Over the short term, the stock market can be extremely volatile. There have been calendar years when market returns have been significantly higher (52 percent in 1954) and significantly lower (minus 43 percent in 1931). However, many investors assume they will earn this rate of return if they stay invested over a long period of time. The question is; how long is long enough; 10 years, 15 years, 20 years?
During a recent seminar, I asked for a show of hands. Every hand went up after 20 years.
While it is true that the stock market has earned an average return of 10 percent, it doesn’t mean that investors should expect to earn 10 percent. The fact is you cannot count on the stock market earning 10 percent, even after 20 years.
The accompanying chart shows the rate of return the stock market earned during the 72 rolling 20-year periods from 1926 to 2016. For example, the top row shows that the stock market earned at least 12 percent in 29 of the 72 20-year periods; a success rate of 40 percent.
The bottom row shows that the stock market earned at least 6 percent in 69 out of the 72 20-year periods; a 96 percent success rate. The shaded middle row shows that the stock market earned at least 10 percent (its historical average return) in 46 of the 72 20-year periods; a success rate of 64 percent. Put another way, there were 26 20-year periods (approximately one-third of the time) when the stock market earned less than 10 percent.
Many investors make their investment decisions based on the stock market returning 10 percent. But what if the stock market returns less than 10 percent?
Consider the following example. John and Paul are both 40 years old and they each currently have $150,000 in retirement savings. They would both like to retire in 20 years with $1 million.
John calculates that if the stock market earns his historical average return of 10 percent, his current $150,000 retirement portfolio will be worth $1 million in 20 years. As a result, John chooses to longer make any additional contributions into his retirement plan. John’s investment plan has an historical (64 percent) success rate of him ending up with at least $1 million in 20 years.
Paul chooses to build an investment portfolio based on the stock market earning a more conservative 8 percent over the next 20 years. As a result, she chooses to save $6,500 dollars each year. Choosing to reduce his portfolio’s return expectations from 10 percent to 8 percent combined with saving $6,500 each year, provides an historical 88 percent success rate of ending up with $1 million after 20 years.
If the stock market ended up returning 10 percent over the 20-year period, John would achieve his goal of retiring with $1 million; however, Paul would end up with $1.4 million. What if the stock market only returned 8 percent? Paul would still end up achieving his goal of retiring with $1 million; John would end up with only $700,000.
The object of investing isn’t about achieving the highest return. It’s about having an investment plan that can provide you with the “highest probability” of achieving your financial goals with the least amount of risk. Too many investors are simply relying and/or expecting the stock market to solely decide the type of lifestyle they will live in retirement.
If your investment plan is based on earning a return of 10 percent and the stock market earns only 7 or 8 percent, you could be living a severely reduced lifestyle in retirement. If you are not comfortable, or willing to take that amount of risk, one alternative is to save more money.
Unlike the performance of the stock market, saving is something that is under your control. The more money you save, the lower the return you need. And as the rate of return you need to achieve your financial goals decreases, the odds of achieving your financial goals increases.
Martin Krikorian is president of Capital Wealth Management, a “Fee-Only” registered investment adviser located at 9 Billerica Road, Chelmsford. He is the author of the investment books, “10 Chapters to Having a Successful Investment Portfolio” and the “7 Steps to Becoming a Better Investor.” Martin can be reached at 978-244-9254, Capital Wealth Management’s website, www.capitalwealthmngt.com, or via email at firstname.lastname@example.org.