What stock market return should we expect?

One benefit of Oblivious Investing is that you can take an “I don’t know, and I don’t care” attitude about market swings and short-term market results. It’s quite freeing when compared to investment strategies that put you at the mercy of the month-to-month whims of the investing public.

Long-term market returns, however, are another story. There’s simply no way to create an investment plan without using something as your projected rate of return.

In other words, while, “I really can’t say for sure.” is the most truthful market prediction anybody can give, it’s also entirely unhelpful.

Darn.

My best guess

The three primary determinants of market return are:

1. Dividend yield
2. Earnings growth, and
3. Shifts in market P/E ratios (caused by changes in the demand for stocks).

Historically, over periods of 30 years or more, the first two factors (the more predictable ones) have made up the bulk of the return, while the third factor (the unpredictable one) has performed a much smaller role–generally either increasing or decreasing the annual return by 1% or so.

At the moment, applying this formula indicates that we can expect a 30-year annualized return between 7.5% and 9.5%.

Where things get tricky

The problem, as Carl reminds us, is that you don’t pay your bills with percentages. You pay them with dollars. And while expected annual returns become fairly predictable over long periods, expected total return becomes less predictable.

The reason, of course, is that a slight change in annual return–when compounded over multiple decades–causes a dramatic change in ending value.

For example, if an investor plans on 40 years of 10% returns, and she gets 40 years of 9% returns, she’ll have only 76% as much money as she planned on having–even though her estimated annual return wasn’t too far off.

So what should we plan on?

Naturally, the prudent thing to do is plan on a conservative rate of return. For example, based on the “dividend yield + earnings growth” formula mentioned above (often called the “Gordon equation”), I’d currently plan on a 7.5% annual rate of return over the next few decades.

(And for any period shorter than a few decades, my answer is still a stubborn “I have no idea.”)

Ongoing (infrequent) monitoring

At least as important as what return you should plan on earning is the question of how to monitor the return you’re earning to see if it’s living up to your expectations. In my opinion, an annual checkup–done at the same time as your annual rebalancing–should be quite sufficient.

If, when looking at your portfolio’s 5-year or 10-year returns, it appears that you’re falling short of your estimates, it’s time to either step up your contributions or adjust your goals.