your investments will return 6% annually, probably

There’s a common assumption that I noticed was being used at Sun’s Financial Diary that the stock market returns 10% historically. I don’t think this is an uncommon assumption. This rate is usually used when making assumptions about how money will grow in the future, and how people should invest their money now. I am not going to suggest hiding your money under the mattress or keeping it all in high-yield savings accounts, but if you choose to invest in stocks, you should consider that your rate of return may actually not ever really approach 8%.

Look at this chart (PDF file). It shows the rate of return of stocks, bonds and treasury bills from 1926-1999. This is a long period of time and covers both bull and bear markets many times over, so it should be useful to form an assumption. The chart also assumes a 31% capital gains tax rate. As recently as 1978 the capital gains tax rate was almost 40%. Only in the 1920s, the early 1930s and the last five years has it been below 20%, so 31% is probably a fair assumption.

Inflation has ranged from a high of almost 9% in the 1910s to a low of 2% in the 1950s (that is the low except for periods of deflation during the Great Depression). The chart uses a 3% inflation rate over time as a rough average.

The end result is this: after inflation and taxes, these investments result in the following returns:

  • US Treasury Bills: -0.05%
  • Long-Term Government Bonds: 0.4%
  • Common Stocks (the S&P 500): 4.7%
  • Small Company Stocks: 5.6%

So given these numbers, using a 10% return on your investments for long-term financial planning is optimistic. Investors should also consider that there have not been any recent massive pullbacks in the market similar to the Great Depression or the extended doldrums of the 1970s, but anything could happen. Imagine, for example, a terrorist attack on a financial center in New York happening again.

I am sure that the numbers can be manipulated in various ways, and many assumptions can be changed regarding taxes and inflation and bull/bear markets.

Keep this in mind, though: during the 20th century the US market was one of the single safest places for your money to be, whether or not you were American. During two brutal world wars that crushed most of the Western world, the US was untouched with the exception of Pearl Harbor. The US will probably never again have that competitive advantage over other markets. New regulatory pressures and a weak dollar have made the European markets attractive again, and even newer exchanges in Russia and the Far East will continue to lure people away from the US markets with wild gains (and wild risk).

Keep in mind, too, that these are broad market investment assumptions. If you try to time your investments, or you invest heavily in individual stocks, you can do far better or far worse. But if you are investing in broad index funds over a 30 or 40 year period for retirement these are good numbers for planning.

So when you are considering investing choices, keep in mind if anyone tells you that the US market has historically returned 10%, or 8%, they are definitely using a ‘best case’ scenario if they want to apply this to future returns. Prudent financial planning requires that you always assume the worst and hope for the best.