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:
- Dividend yield
- Earnings growth, and
- 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.
A message never made often enough. Well done.
I think predicting the stock market is like predicting the weather. It’s not possible to guess accurately. There are far too many factors and unknowns.
Planning on something that you have no control over and cannot predict might not be such a good idea…
I think it’s better to find another way to get rich or invest…
Insightful post. I think you make a good point about not being able to truly predict returns. Any investment is the same. It’s just not possible to predict what the final returns will be. Which is why I like the idea of have passive income streams, along with dollar cost averaging in index funds and value investments (I like companies with DRIPs) and building a solid cash emergency fund. It sort of helps you cover your bases. And, if you start young enough, chances are you’ll build up enough to account for inflation and give you what you need down the road…
@B7 If you give up on stocks because they are unpredictable you are going to be stuck with lower, but predictable returns. There has to be additional compensation for that unpredictability or no one would ever invest in stocks!
Why not plan using the lowest estimate? If you can reach your goals with a 7.5% annual return then you will have far more than you need if the market fairs better.
-Rick Francis