Many people are counting on an 8% compound interest to get them to retirement. Where on earth did that number come from? Is it at all a reasonable expectation?
What is the Long-Term Return on the S&P 500?
Here is a graph of the January 1st values of the S&P 500 since inception (1871):
Add a trend-line and here’s what you get:
With the trend-line exponent of 0.0436, you could say the average S&P 500 return is 4.45%.
As you can see, the first 100 years are not even the same ball game as last few and all of those low gain years skew the trend-line way down. To give us a better idea of what is going on, here’s the graph again with a new trend-line, containing only data after 1971. Why 1971? In 1971 we got the “Nixon Shock”, or rather when the US Dollar decoupled from gold. Since 1971, the rules of money have been different (see What is Money? and the US Dollar Machine).
As you can see, this fits the data MUCH better. With the trend-line exponent of 0.0784, you can back out an average return of 8.16%. I guess that is where financial planners came up with their expected 8% return.
Side Note: I can’t help but notice that the trend-line marks the bottom of the dot com bust and the trigger of the real estate crash. It could be self-created by Excel’s trend-line algorithm, or it could mean things get exciting when we touch the trend-line.
The only problem is that after 1995, with the Dotcom Bubble, the data gets wild.
If we do a third date range only including 1995 and later, here’s what we get:
Unfortunately with a trend-line exponent of 0.043, we are back down to 4.40%. Now I understand that I’m looking at much less data now making the numbers somewhat cherry picked. It is over 20 years though. 20 years is definitely significant in a 40 year career path. I don’t really care if I can count on a 100 year return of 8%. I don’t plan on working 100 years!
Things probably won’t work out the way they did over 20 years ago. Can we really pull numbers to predict the future from before Bill Clinton and Greenspan (former Chairman of the Federal Reserve) started playing with money? I’m worried we can only really expect the 4-5% return until money game shifts again. When it does, who is to say it will be back to the 8% we got for only a few years?
It all comes out in the inflation wash
If you read my explanation of what inflation really is, you understand that we are really hovering around a 5% inflation! In other words, unless the stock market performs higher, your gains are just adjusting your money to inflation. If you have a mixed portfolio with bonds, you’re loosing to inflation. By all means, that is much better than loosing 5% to inflation, but it does make retiring a challenge.
I re-ran my retirement numbers with the following grim assumptions:
- Any money you gain in the stock market will be negated by inflation
- Any pay increases you gain will be negated by a higher cost of living and taxes
In effect, it is as if we just kept replaying today over and over until retirement.
The good news is with theses assumptions, we expect to be millionaires in today’s money before I’m 50! The bad news is my husband will have to work till he’s 67 before we can retire. Luckily, I should eventually be able to help him out, so I doubt it will really be that long. The numbers are still sobering though. Even maxing out our 401K ($18,000/year) isn’t necessarily going to cut it.
If you want to run your own numbers with these conservative assumptions, here’s a simple free spreadsheet.
The good news, is I’m most likely wrong. Looking back at the 1971-2017 graph, the crazy bubbles and crashes still seem to loosely follow the 8% trend-line. Maybe an 8% return is a valid expectation.
We’ve Always Bounced around the Trend-Line
I cropped the data at other ranges so you could see how the earlier data looks zoomed in. We have always bounced around the trend-line, you just couldn’t tell in the large graph because a drop of 14 in 1929 was a 44% devaluation, but today it is about a half a percent.
I really don’t know the monetary significance of 1985. I’ve tried looking it up as well as the surrounding years, but I don’t see anything except “Black Monday” in 1987. I do, however, see lots of reports that start tracking at 1985, so I know I’m not the only one seeing the shift. One guess is that in 1986 London’s exchange did some massive deregulation. Maybe the United States started the trend a year earlier?
As you can see, with this cropping, the crazy bubbles and bursts of recent years look just a little bit better. Of course, that is probably because there is less data, skewing it towards the later years. The good news is this trend is 7.30%. Even I don’t think inflation is that high.
One final graph should help a lot:
This is all of the data again, but graphed logarithmicly (split at 1918, 1948, and 1971). This type of graph makes the most sense because we are assuming exponential returns. Suddenly the recent crashes look a lot less scary and the steep incline looks a little more stable.
If anyone is telling you long term rates (especially Dave Ramsey’s crazy 12% expectation), ask how they derived those numbers. The data can be cropped, skewed, and made to tell anything you want. When it comes to something as important as retirement planning, you’ve got to do your own thinking (and don’t forget inflation!).
Disclaimer: I am not a licensed or certified financial coach, planner or adviser, just an enthusiast. Anything I recommend should be personally analyzed and discussed with your financial adviser.