This week’s blog post is inspired by Marcus Crassus. Marcus, or “Mark,” as his friends call him, made a small fortune in real estate – and is now turning his eyes to stock market investing. Recently, I had a conversation with this ambitious individual about the expected stock market return. Our talk began with Mark asking:
How much stock should I hold in my portfolio to get an investment return of 30% a year?
[subtitle3] Stock Bond Allocations[/subtitle3]
Before we answer Mark’s question about expected stock market returns, we need to put this question into context. Know that investment portfolios are (usually) composed of a mix of stocks and bonds. (You’ve probably seen a visual representation of this stock/bond mix before in a pie graph.)
This pie graph is not very informative, but it is delicious.
This melding of stocks and bonds serves a purpose, with each investment’s strength balancing the other investment’s weakness:
- Stocks provide high returns, but at the cost of high risk.
- Bonds offer low risk, but at the cost of low returns. (Although, now many can make the case that bonds are risky too.)
The more stock (relative to bonds) an individual holds, the higher the potential for investment return. The more bonds (relative to stocks), the safer the investment is.
[subtitle3] What is a Good, or Average, or Moderate Stock / Bond Allocation Mix?[/subtitle3]
Consider a popular stock/bond mix: The 60/40 (as the name suggests) is a portfolio composed of 60% stocks, and 40% bonds. This is a moderate allocation – not too risky, but not too safe. Those fearful investors may consider an allocation with less than 60% stocks, while aggressive investors may utilize an allocation of more than 60% stock.
[subtitle3] What Percent Stock Allocation Does Mark Need to Achieve a Stock Market Return of 30%?[/subtitle3]
Now let’s return to Mark’s inquiry. Mark says:
Can I run with the standard mix of 60/40 to get my 30% stock market return?
No. You’ll need more stock than just 60%.
How about 70/30?
Ok. How about 90/10?
I’m afraid not.
You mean I have to put my entire investment into stocks to earn a 30% stock market return?! But that’s so risky!
Mark is only partially right. Yes, it is indeed risky to put one’s entire portfolio into stocks. However, Mark is wrong about the 30% stock market return part. To get an annualized (compounded annually) 30% stock market return, Mark would probably need a 200/0 allocation. Yes, Mark would need a portfolio composed of 200% stocks. Anyone familiar with math knows that anything over 100% is not possible.
(However, one could achieve a 150/0 through the use of leverage, with a margin account. But, know that any investment return must be netted against the cost of leverage, i.e. the interest rate charged for the funds borrowed.)
In short, achieving a sustained 30% stock market return is highly unlikely to happen.
[subtitle3] What Sort of Numbers Can the Stock Market Provide?[/subtitle3]
Upon hearing that he will never be able to achieve his sought-after 30% stock market return, Mark becomes skeptical – especially in light of last year’s stock market performance of 33%! And yes, Mark is absolutely right. Last year posted a very impressive stock market return. But, as I explain to Mark, and this is a big BUT, on double-digit timelines (i.e. ten years or more), stock market returns are never that high.
Historically speaking, here’s what you can expect:
- Stock Market Return: From 1928 to 2013, the S&P 500 generated a return of 9.6%.
- Treasury Return: 10-year Treasury bonds returned 4.9%.
- Portfolio Return: A 60/40 portfolio generated 8.2% (assuming annual rebalancing).
Note that the above figures are nominal returns. That is, these numbers are not adjusted for inflation. With inflation averaging around roughly three percent (3%) for the same period, you can expect a real (i.e. inflation-adjusted) return of about three percent less than the figures quoted above.
Also, any financial advisor will tell you that past performance is not indicative of future results. Going forward, the stock market returns we have seen in the past may no longer be available. This is because interest rates are near historic lows, and stock market valuations are near historic highs.
At 2.3%, the 10-year Treasury is currently offering a return of less than half its historical performance. For the S&P 500, this is only the fourth time (since data was available in the 1800s) that the Shiller PE has moved above 25. Investment geek speak aside, this leaves little opportunity for investment growth.
So, while there will always be high stock market returns because of bull markets (like we’ve had recently), there will also be bear markets to level out those high stock market returns. Knowing what sort of stock market returns are probable can help you develop your financial plan.
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Understanding what you can expect from your investment portfolio can help you plan for retirement. If you’re unsure how to allocate your investment portfolio, work with a fee-only financial planner to help you evaluate your risk tolerance. As a fiduciary, a fee-only financial planner can examine your unique financial circumstance, determining what sort of stock/bond mix will work best for your particular financial situation – without the conflict of interest that comes from the desire to earn commissions from the sales of financial products.
Office of Debt Management. (2014, November 20). Daily Treasury Yield Curve Rates. Retrieved from U.S. Department of the Treasury: http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield
Shiller, R. J. (2005). Irrational Exuberance. Retrieved from Irrational Exuberance: http://www.irrationalexuberance.com/index.htm
Shiller, R. J. (2006). Irrational Exuberance. New York: Broadway Books.