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Unrealistic Return Assumptions
Traders Magazine Online News, December 28, 2018
There is no shortage of stupid people tricks in the financial markets, but probably the worst thing people can do is to have unrealistic return assumptions.
Question to you, dear reader. On a long-term basis, what can you expect your annual returns to be in a broad-based stock market index?
- 6 percent
- 8 percent
- 10 percent
- 12 percent
The answer is E. We have no freaking clue! All we know is what stocks have returned in the past. We have no idea what they will return in the future. The conditions that led to prior returns may not be present for future returns.
Most people will tell you that you can expect to earn 8 percent from the stock market per year. That is about what it has returned historically. So, a little perspective. That 8 percent annual return (over a period of about 100 years or so) easily beats any other stock market in the world. Why is that?
It’s because America has the rule of law, property rights, all that jazz. We have something special here in the United States that other countries don’t have. We have a legal framework that protects private property. This lets financial markets flourish. You see that in varying degrees as you travel around the world. The really dastardly places don’t have stock markets at all.
Anyway, it makes sense that a loss of respect for private property rights or the rule of law might lead to diminished stock market performance. That is one reason the stock market might not return 8 percent. I can think of a bunch of other reasons why stock markets might not return in the future what they have in the past, and a big one is that they have just become so freaking expensive. When stocks get overvalued, forward returns go down. Few people disagree with this.
There are lots of smart people out there who expect future stock market returns to be much lower than they have been in the past. It is not just me being a crank.
Stupid and Irresponsible
The problem is, people take this 8 percent number and extrapolate it out in the future, and they break out Microsoft Excel for the first and only time to figure out how much they need to save every month in order to retire at age X. The FIRE dillweeds have made big news because they think that you can retire at age 35, and yes, they are relying on that generous 8 percent number (or higher) to reverse engineer a future standard of living.
This is dangerous. If you have unrealistic return assumptions for the stock market, you will:
- Retire earlier, when you should actually retire later—and you will run out of money.
- Consume more, when you should be consuming less—and you will run out of money.
- Invest, instead of paying down debt, which could result in capital losses to go along with increasing debt balances—and you will run out of money.
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