You Can’t Count on 7%

The long-term annualized, real (i.e., inflation adjusted) return of the stock market (S&P500) is 6.5% to 7.0%. If you have 50 to 60 years, you can count on it.

A better interval would be 30 years. The overall stock market goes from good-to-bad-to-good or from bad-to-good-to-bad in 30 to 40 years.

For retirees, the much shorter interval of 10 years is especially important. By year 10, 11 or 12, a retiree's portfolio has usually grown enough to assure success or it is already in danger.

What can you count on? It certainly isn’t 7%.

S&P500 Tables

I have tabulated the annualized, real, total returns of the S&P500 for periods of 10, 20 and 30 years.
S&P500 Returns

An annualized return at year N is the single rate r that satisfies the equation: balance after N years/initial balance = (1+r)^N.

Real returns maintain their purchasing power. They are adjusted for inflation.

The total return includes reinvested dividends. Here, it excludes deposits and withdrawals.

10-Year Returns

The 10-year total return was NEGATIVE in 1909-1912, 1937 and 1965-1973. [The total return was –0.0025% in 1937.]

The worst years for retirees with high stock allocations included 1965-1973, but not the years of the Great Depression. There were a few instances in which stocks reduced a retiree’s Historical Surviving Withdrawal Rate. He would have been better off putting all of his money into commercial paper (i.e., money market funds).

This is the regression equation for the 10-year stock return and the percentage earnings yield 100E10/P (using 1923-1972 data): y = 1.5247x-4.5509 where y is the annualized real return in percent and x is 100E10/P or 100/[P/E10]. The confidence limits are plus and minus 6%.

Today’s earnings yield is close to 3.5%. The annualized, real, total return at today’s valuations is 0.79%. The confidence limits are minus 5.2% and plus 6.8%.

The estimated total return equals zero when the earnings yield x equals 2.98% or P/E10 = 33.5.

The estimated total return equals 7% when the earnings yield x equals 7.58% or P/E10 = 13.2. The confidence limits are 11.51% with P/E10 = 8.7 and 3.64% with P/E10 = 27.5.

20-Year Returns

The 20-year total return remained positive throughout 1871-1980. It fell below 1.0% in 1901 and 1962. It was between 1.0% and 2.0% in 1899, 1902, 1929, 1960 and 1963-1966. Once again, the 1960s dominate. For investors (in the S&P500), those years were worse than the Great Depression.

This is the regression equation for the 20-year stock return and the percentage earnings yield 100E10/P (using 1923-1972 data): y = 1.0849x-1.4488 where y is the annualized real return in percent and x is 100E10/P or 100/[P/E10]. The confidence limits are plus and minus 4%.

Today’s earnings yield is close to 3.5%. The annualized, real, total return at today’s valuations is 2.31%. The confidence limits are minus 1.7% and plus 6.3%.

The estimated total return equals zero when the earnings yield x equals 1.34% or P/E10 = 74.8.

The estimated total return equals 7% when the earnings yield x equals 7.79% or P/E10 = 12.8. The confidence limits are 11.47% with P/E10 = 8.7 and 4.10% with P/E10 = 24.4.

30-Year Returns

The 30-year total return remained above 3% throughout 1871-1980. It was between 3.0% and 4.0% in 1889-1892 and 1902-1903. Since 1921, the total return has fallen between 4.0% and 5.0% in 1952, 1955-1957 and 1959-1966.

This is the regression equation for the 30-year stock return and the percentage earnings yield 100E10/P (using 1923-1972 data): y = 0.4159x+3.764 where y is the annualized real return in percent and x is 100E10/P or 100/[P/E10]. The confidence limits are plus and minus 2%.

Today’s earnings yield is close to 3.5%. The annualized, real, total return at today’s valuations is 5.22%. The confidence limits are 3.2% and 7.2%.

The estimated total return is 3.76% when the earnings yield is zero. The estimated total return is always above 1.76%, which is 3.764% minus 2% (rounded) [with a confidence level near 95%]. For the estimated total return to equal zero, the percentage earnings yield x would have to be negative.

The estimated total return equals 7% when the earnings yield x equals 7.78% or P/E10 = 12.9. The confidence limits are 12.59% with P/E10 = 7.9 and 2.97% with P/E10 = 33.6.

Data Summary

Stocks are always the best investment..except when they are not.

TIPS are expected to perform slightly better than stocks over the next decade starting from current valuations. There is a lot of uncertainty in the stock returns. Today’s TIPS provide real interest rates between 1.7% and 2.0%. Stocks are expected to return 0.8%. The range of stock returns is minus 5.2% to plus 6.8%.

Stocks are slightly more attractive than TIPS over the next 20 years starting at current valuations. Stocks are expected to return 2.3%. Today’s 20-year TIPS provide real interest rates of 2.0%. There is a lot of uncertainty in the stock returns. The range of stock returns is minus 1.7% to plus 6.3%.

Stocks are more attractive than TIPS over the next 30 years. Today’s TIPS can provide real interest rates of 2.0%. Stocks are expected to return 5.2%, which is low by historical standards. There is still a lot of uncertainty in the stock returns. The range of stock returns is 3.2% to 7.2%.

There is a significant chance of a loss when holding stocks for 10 or 20 years. At 10 years, the odds of a loss are almost even. The odds that stocks will perform better than TIPS over the next 20 years is better, but still close to being a coin toss.

There is a slight chance that stocks will return 6%+ over the next decade or two. It will take more than three decades for the odds to rise to 50%-50%. It takes three decades before we see even a hint of a 7% return.

Or..we can wait for better prices.

Remarks

Your odds of a favorable stock return improve greatly if you wait for favorable valuations.

Reject the mindless advice to buy stocks right away regardless of costs. If you do that, it will take three decades before you can be comfortable about making money.

These calculations were based upon making no deposits or withdrawals. I addressed the effects of deposits and withdrawals in An Illusion of Numbers. In essence, the returns that you get from your investments are most important when you have the most money. Typically, this is just before and just after retirement. Those who have retired in the last 10 to 15 years have received the benefit of a favorable market. Their portfolios have grown substantially. Today’s retirees can expect to face a more difficult period.
An Illusion of Numbers

Prices matter. Prices matter a lot. Insist on getting a good price, a reasonable price, but not necessarily a great price.

Have fun.

John Walter Russell
July 31, 2005