March 1st 2024.
In recent months, I've come across various individuals in the financial industry struggling to provide accurate predictions for future investment portfolio returns. While there is no easy answer, these estimates are crucial for effective planning. Many people tend to rely on past trends and averages, assuming that they or their clients will experience similar returns in the future.
Starting with the historical average is a good place to begin, but it's important to make some adjustments to improve the accuracy of our forecasts. So, I'd like to share some thoughts and tips on this topic.
First and foremost, it's essential to understand whether the returns you're looking at are adjusted for inflation or not. Ideally, we want to work with real rates of return, but if that's not possible, be sure to know whether the numbers are adjusted for inflation or not. Otherwise, it can be challenging to make sense of the data.
To illustrate this point, let's take a look at a blog post from a few years ago by Ben Carlson. He stated that the worst-case scenario for all stocks resulted in an 8% return. However, he failed to mention that this number was not adjusted for inflation, which makes a significant difference. The adjusted return is closer to 2.5%, which is a vast disparity.
To put this into perspective, earning an 8% return means doubling your money every 9 years, while a 2.5% return means doubling your money every 29 years. That's a significant difference that can have a significant impact on your financial planning.
It's worth noting that some tools, such as Portfolio Visualizer, allow you to adjust for inflation, which can provide a more accurate representation of your investments' potential returns.
Another crucial aspect to consider is the variability of investment portfolio returns. It's crucial to understand that there are no guarantees when it comes to investing in the stock market, even over a long period. For example, let's say you invested $1 million in a retirement account, paid low fees, and invested 100% in US stocks for 30 years. According to historical data, the median adjusted return is around 6.56%, which is a solid return for retirement planning.
However, the worst-case scenario resulted in a 2.57% return, and 5% of investors earned 3.96% or less. This variability in returns can have a significant impact on your financial goals, and it's crucial to acknowledge and plan for it.
It's also worth noting that these calculations are based on a single initial investment. If you plan to save annually or make additional investments, these numbers will look different. Therefore, it's essential to use tools that reflect your investment strategy accurately.
Fees and expenses are another crucial factor to consider when estimating investment portfolio returns. While low fees may seem insignificant, they can have a significant impact over the long term. For example, a 1% fee on a $1 million investment would result in $10,000 annually, which can add up over the years. It's crucial to factor in these fees and understand their potential impact on your returns.
Lastly, it's essential to consider current market conditions when making return estimates. With the US stock market at record highs and interest rates continuing to decline, it's reasonable to assume that future returns may not mirror the past. This doesn't mean we should deviate from traditional investment strategies, but it's essential to adjust our expectations accordingly.
To end on a positive note, I'd like to remind you that these adjustments and considerations do not mean we should abandon traditional investment strategies. Following the advice of industry experts and sticking to low-cost, passive investing is still the best approach. However, it's crucial to be aware of these factors and make necessary adjustments to ensure a more accurate representation of your investment portfolio returns.
If you're feeling discouraged after considering these adjustments, don't worry. The practical solution for most people is to save more or work longer, which can make a significant difference in the long run.
For more resources on this topic, check out my blog post on CAPE fatigue and the importance of having a backup plan for retirement. Remember, it's crucial to understand and account for these factors when estimating future investment portfolio returns.
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