The best way to give up your ‘day job’ is to watch my Live Show this Thursday @ 8pm CST (9pm EST / 6pm PST) at http://ajcfeed.com ….
Just yesterday I wrote a pretty long piece about the effects of inflation, and how much you could reasonably expect to save for retirement …
… it turns out that you need to save a lot (per week) to get a little (to live off per year, in today’s dollars).
If you followed along, you would have realized one thing … I used a very conservative annual expected return on my investments of only 8%.
This got me to thinking … what annual rate of return should we be using? Isn’t the historical rate of return from the ‘market’ (hence an broad-based Index Fund) around 12% – 14%?
Let’s face it, the difference between investing $100,000 for 20 years at the 8% and 12% is not the 50% more that you would intuitively expect …
It’s actually a difference of $430,000 or exactly 100% !
That means that whether you make an 8% return or a 12% return is the same as doubling your ‘salary’ in retirement … compounding greatly magnifies success (and, failures!), especially over long periods.
Since the average return for the stock market is 12%, we should use that, right and just double all the numbers that I gave you yesterday [phew!] … right?
Trent from the Simple Dollar asked that exact same question … on June 17, 2007; here’s an excerpt from that post:
Another favorite of mine is the ongoing debate over the Vanguard 500. The Vanguard 500 is an index fund started in 1976 that precisely mirrors the S&P 500, a collection of the stocks of most of the largest companies in the United States. Since its inception, it has averaged a return of over 12% per year. Given that, I often use a 12% annual return as a number to use to calculate annual returns in the stock market over a long term (longer than ten years).
I will never be bold enough to say that I’m absolutely correct and the 12% annual average will hold up, but if you ask me what I thought, I’d say that it will, at least for a while, and I’d dump several reasons on your lap. Someone else would likely disagree with this and deliver several reasons why it won’t happen. I know at least one person with a degree in economics who firmly believes that the next several years will be much betterthan 12% as several new industries come online with marketable products. Who’s right? Only the future can really tell.
How has the market actually fared over the past 10 years?
No, the broad S&P 500 Index that Trent referred to averaged just somewhere between 2% and 4% over the past 10 years!
The Dow Jones Industrial Index that measures a smaller basket of larger companies averaged just somewhere between 4% and 6% return [AJC: Why the range? There was a major crash exactly 10 years ago, so do we assume we go in at the top or at the bottom?].
Isn’t it great having the benefit of 20/20 hindsight? Does it mean that trent isn’t smart?
No, Trent’s a pretty smart cookie … so am I, and so are you … even smart people get stuff wrong!
For example Warren Buffett (who I like to quote – a lot – on stock market-related topics, because he is regarded as the World’s Greatest Investor) has made some doozies that he openly admits to; here’s just one of them, according to USA Today:
Buffett conceded that he has made what he considers mistakes, including a reluctance to buy large amounts of Wal-Mart stock several years ago. “I cost us about $10 billion,” said Buffett.
I guess for Warren a $10 Billion mistake is the same as a 8% – 10% mistake for us?
Actually no, if you were planning for a 12% return but only got a 4% return, for every $100,000 that you invested for just 10 years, you would ‘lose’ $650,000 – your estimates of future income would be out by a factor of 3 (that’s just like getting a 2/3 pay cut)!
So, here’s what I recommend … as I said yesterday, averages are for everybody – what might happen to everybody anytime.
You are special … you are investing whenever you invest [AJC: stick with me on this!] … and, you have to live forever more with the consequences.
This means that you should plan for the worst case … and smile when the result is better.
So, if you decide that $1,000,000 in 30 years is enough [AJC: I hope, by now, that most of my readers are planning a LOT more a LOT sooner!] and you are willing to take a chance on the averages (i.e. 12% returns), then by all means set aside just $60 a week (starting now) … but, make sure that you index it for inflation (means that you will be saving $85 a week by year 10; $127 a week by year 20; and, $187 a week towards the end).
But, if you want to be certain that you will have $1,000,000 in 30 years, then you had better start by putting aside $110 a week (and, increase to $157 a week by year 10; $232 a week by year 20; and, $343 a week towards the end) … because the market only guarantees an 8% return for every 30 year period in history!
What does this mean?
Aim for the certainty … don’t leave it to chance [a.k.a. historical averages]!
What can you do?
1. Decide whether a different type of investment would be better for you (e.g. direct investments in stocks; or leveraged real-estate; or businesses) in which case you can save the same amount per week and (hopefully) achieve better returns to get you there … i.e. concentrate on investing rather than building income.
2. Increase your income, so that you can just dollar-cost-average into the broad-market Index Fund … i.e. concentrate on actively creating income rather than actively investing the proceeds.
3. Do a little of both.
This blog is aimed at squarely at those who want to do a little of both …