Pessimistic Math and 12% Returns

by | May 9, 2011 | Fee Only Financial Planning, Weekly Column | 6 comments

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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