How high should our expectations be for investment performance over the long haul? Over the last 50 years the S&P 500 has earned an annual return of 9.5% per year on average. Dave Ramsey’s Financial Peace University uses a 12% annual return in the mutual fund section of the class. There’s many other seemingly reliable sources out there saying the stock market earns 10% per year.
Which is right? Is this really important to your investment and retirement timeline?
Why Investment Return Matters
If you know anything about finance you know that a large chunk of your portfolio’s growth will come not from the original principal you invested, but from the growth (on top of growth, and so on) on that investment. Any impact to the growth on your investment principal can have a huge impact on your retirement.
If you’re expecting your portfolio to return 12% per year and it only returns 6% per year you may have no choice but to retire later than you want. The longer you can go without touching your nest egg the larger it will grow (assuming you aren’t taking huge risks as you near retirement). Even a change from 12% to 9% can have a massive change on your ability to retire.
Let’s say you have $100,000 and will contribute nothing else toward retirement. Your goal is to retire with $1,000,000 in the bank. If you invest the lump sum up front and contribute nothing afterwards, and earn a 12% return over 20 years you will end up with $1,080,385.
If you earn 9%? Only $610,881. That’s a difference of $469,504. You would need to wait 6 more years to hit $1,000,000 to be able to retire.
The news is worse if you only earn a 6% annual return. After 20 years you’re sitting with $339,956 and would need another 19 years to hit $1,000,000. This really shows off the power of compound interest.
Not many of us have an extra 20 years to dedicate to working while we wait on our portfolio to grow to $1,000,000. To make up for a lack of investment performance you would need to invest more money into your portfolio.
Let’s look at that dire 6% annual return from above. If you invested the initial $100,000 and also invested another $5,000 per year, even though you’re only earning 6%, your portfolio would grow to $551,918. It would take an extra 10 years to break the million mark, saving you 9 years compared to not contributing.
Saving Even More
If you upped your contributions a bit to $10,000 then you get a lot closer with a 6% annual return. Instead of waiting 30 years to hit $1,000,000, you hit it in 24 years. Not quite the 20 years we were enjoying with the 12% returns but likely more realistic.
Lower Your Expectations and Adapt
Do you see what happened there? Over that 20 year period you invested another $100,000 (20 years x $5,000 per year), but your portfolio jumped $1,405,172! That’s huge and points to the power of mixing a little bit more saving with a lesser interest rate. While it would be great to earn that 12% return while also consistently investing – your portfolio would be huge – it may not be possible to reach that high of a return without an extraordinary amount of risk.
Updated February 23, 2013: I made some pretty bad Excel calculation errors when I first did this post, and I haven’t looked at it since. Not sure where the error came in, but your portfolio obviously doesn’t jump to $1.7 million by just contributing $5,000 per year. I think what I did is I put the growth rate back to 12% while adding in the extra contributions. That gets you to the $1.7 million ballpark. I apologize for the error.
My personal investment return expectations are around 7%. Hopefully that is a pretty low number. Our portfolio and how much we save every year for our retirement goal is based on 7%. Setting a low expectation and getting a nice surprise (we earned 9%, woohoo!), in my opinion, is better than setting a high expectation and being disappointed when your goals aren’t reached on time.