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Pessimistic Math and 12% Returns

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Optimism and positive thinking are important assets in a great many areas of life. When it comes to investing, though, a healthy dose of pessimism may be a lot more useful.

This is especially true when it comes to estimating long-term returns and projecting the level of income you can expect in retirement. Any investment advisor who tells you to expect average returns of 10%, 12%, or more is either an unreasonable optimist or an opportunist. The actual numbers for past investment returns over time simply don’t support such high percentages.One of the consistent optimists when it comes to predicting investment returns is radio talk show host Dave Ramsey. His website contains some great advice when it comes to investing, such as maxing out 401(k) accounts first if you have them, not buying individual stocks, and investing consistently over time.

Where Ramsey’s unreasonable optimism comes into play is his assumption that growth stock mutual funds will give you average returns of 12%. His website says: “Over the last 30 years, the S&P 500, a standard measurement of stock market performance, has averaged a 12% growth rate.”

Based on the assumption of 12% returns, then, Ramsey says retirees can withdraw 8% a year from their portfolios, leave in 4% to cover inflation, and thereby maintain the buying power of their principal. Obtaining a 12% return depends on two assumptions: that having 100% of your portfolio only in stocks is a good idea, and that such a portfolio will return 12%. Both of these assumptions are mistaken.

Thomas De Jong, a financial planner from Sioux Center, Iowa, who is affiliated with Money Concepts International, recently sent me an article pointing out that Ramsey’s 12% figure is “not even close to accurate.” He does the math to show us why. The following paragraphs are from his article:

“From January 1, 1926 to December 31, 2009, the stock market returned an ANNUAL AVERAGE rate of 11.92%. That’s pretty close, right? No. That’s NOT the compounded, or annualized rate of return, which you need to use if you’re going to forecast how your account grows over time (true rate of return).

Here’s an example: You have $10,000 in an account. In year one, you make 100% return, doubling your money to $20,000. In year two, you lose 50%, cutting your $20,000 in half back down to $10,000.

Annual average returns add your returns together and divide by the number of years. So 100% – 50% = 50% divided by 2 years = 25% annual average returns. However, at the end of 2 years, you only have your original $10,000, so you actually made ZERO.

True rates of return are compounded, or annualized. The ANNUALIZED rate of return of the market from January 1, 1926 to December 31, 2009, was 9.84%. Adjusting for inflation, the stock market has returned 6.63% on an annualized/compounded basis from 1/1/1926 to 12/31/2009…and that’s before investment expenses and taxes!!”

De Jong and I might be considered pessimists, but we’d say we’re realists. The numbers he cites are the reason I estimate returns for my most aggressive portfolio at 8.0% and my most conservative at 5.0%. This is also why I agree with the conventional wisdom of limiting retirement withdrawals from a moderate portfolio, invested in an equal balance of stocks and bonds, to 4%. That percentage is based on a strong body of research by investment professionals.

Maybe my projections are overly pessimistic. So much the better. If my clients are going to be surprised by returns different from what I’ve estimated, I would much prefer those surprises to be happy ones.

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13 Responses to Pessimistic Math and 12% Returns

  1. Bobbie Munroe May 9, 2011 at 10:04 am #

    Ramsey’s optimism does not allow for the irregular nature of returns. What if all the low number in the “average number” come first? As you pointed out, big difference in the result. “Average” is an overused and often misleading term. Also, it is the return relative to inflation. As I’ve told my clients, over the “lost decade” my clients made approximatelyu between 4 and 7%. Not great but inflation was SO low this really looks as good as MUCH higher numbers with “average” inflation. I suppose Ramsey will be out the public eye by the time all those who follow that 8% withdrawal advice run out of money.

  2. Martha O'Brien May 9, 2011 at 10:48 am #

    It amazes me that media personalities like Ramsey, Clark Howard and others are allowed to pass out generic, over-simplified advice to millions with no worries about crossing swords with the regulatory authorities, because they aren’t required to be licensed. Nuts to me. Those who reach millions need no license, but the one who touches hundreds comes under control of the well-intentioned governing authority. Who has more potential to do harm?

  3. Tom W September 28, 2011 at 5:02 pm #

    When this “optimism” is so widespread in the industry, though, how can one compete as a “realist,” promising lower returns than 95% of their competition? That’s the question. If the answer is “they can’t,” then realism, sadly, has no chance.

  4. TJ December 17, 2011 at 8:35 pm #

    Realistically, though, there are investments that offer 10-15% in annual returns — such as note and trust deed investments. In the last couple of years we’ve seen many investors taking money out of stocks and/or using self-directed IRAs to make loans to borrowers secured in first position on real estate at these higher rates. Especially since banks are more reluctant to loan, the demand for short-term, non-conventional loans are on the rise. I’m not sure why more investors and investment advisors don’t include these types of investments as options…

  5. Matthew Johnson October 5, 2012 at 12:17 pm #

    Rick Kahler, you are not correct in your logic. You are not using the correct mathematical numbers in your reasoning.

    The statement above is NOT CORRECT. Here’s what it should look like:
    [ (100% of Principal) – (50% of (Principal + Gain)) ] / 2

    In order to compute the average gain, you must make all percentages in the same terms:
    [ (100% of Principal) – (50% of (Principal + (100% of Principal)) ]
    = 100% – (50% of (200% of Principal))
    = 100% – 100%
    = 0% Avg Gain

    There are no tricks in percentages like you were thinking. If you invest $10,000 in an ETF for the S&P 500, you will probably average around a 12% increase each year. Let me walk through an example with made up numbers.

    Year 1: S&P returns -30%
    You now have $7,000

    Year 2: S&P returns 20%
    You now have $7,000 + (.2 * $7,000) = $8,400

    Year 3: S&P returns %40
    You now have $8,400 + (.4 * $8,400) = $11,760

    The average gain of the S&P 500 is not [ (-.30) + (.20) + (.40) ] / 3
    The average gain is [ (11,760 – 10,000) / 10,000 ] / 3
    = (1,760 / 10,00) / 3
    = .0587
    = 5.87% Avg Gain

  6. jimb April 27, 2013 at 1:30 am #

    Matthew Johnson, you are not correct in your logic. You are not using the correct mathematical numbers in your reasoning either. Your 5.87% and how you reached it is incorrect because it’s compound interest.

    The result for each year is calculated on the total from the previous year. So you can’t just divide by 3. You have to solve for the exponential CAGR (Compound Annual Growth Rate) … or geometric mean.

    We know from the example that the end result is $11,760 but using your calculated average of 5.87%,
    =10000 * (1+5.87%) * (1+5.87%) * (1 + 5.87%) …. Gives 11,866

    In this case it would be =((1-30%) * (1+20%) * (1+40%)) ^ (1/3)-1 … which gives us 5.553%.

    Using the actual yearly yields, =10000 * (1+-30.%) * (1+20.%) * (1 + 40.%) …. Gives 11,760

    Using the 5.553% APY or CAGR, =10000 * (1+5.553%) * (1+5.553%) * (1 + 5.553%) …. Gives 11,760

    The RATE function in most spreadsheets will do the repetitive work for us: =RATE(3,0,10000,-11760) … Gives 5.553%

    And the FV function multiplies it out for us: =FV(5.553%,3, 0, -10000) … Gives 11,760

    jimb

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