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The 10% Return on Equities Myth

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According to historical records, the post-war return of the stock market has been around 12%. It’s a number that has used over and over again (more often people use the 10% value) as the benchmark for stock returns and project of future results, since it’s better than pulling a number out of thing air. However, yesterday afternoon I had the pleasure of reading Warren Buffet’s 2007 Letter to Shareholders of Berkshire Hathaway (if you’ve never read one, you should because it is both informative and entertaining, 2008′s is a mere 21 pages long and chocked full of fun facts).

On Page 18, right after Buffett chastizes 498 of the Fortune 500 for not recording stock options as expenses on their books, he starts talking about the Dow returning 5.3%, compounded annually, in the 20th Century. Wow, what happened to this 10% business? Why are we using it as a benchmark if the Dow’s return over the last hundred years (arguable, the last hundred years starting 8 years ago) is a meager 5.3%? I don’t know, but even assuming 5.3% is pushing it.

Buffett goes on to illustrate that a 5.3% annualized gain going forward would mean the Dow would have to pierce 2,000,000 (that’s two million!) by the end of 2099. That’s working with only 5.3%. If you want 10% annually then you’ll need the Dow to hit 24,000,000 by 2100. Twenty four million…

Though, nominal numbers are merely that, nominal. If you asked someone at the start of the 20th Century if the Dow was going to grow from 66 to 11,497 (especially after you told them the horrors that would come during the Great Depression), they probably would’ve laughed too. So, will Warren Buffett’s prediction that a 10% is outlandish and unreasonable hold true?

I don’t know but I’ll tell you what… while historical returns are not indicative of future results, Warren Buffett’s historical returns are better than my historical returns so I’m siding with him on this one.

{ 9 comments, please add your thoughts now! }

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9 Responses to “The 10% Return on Equities Myth”

  1. Bill says:

    I agree that 10% isn’t what you should assume for personal projections, but at the same time, the Dow Industrials does not equal the market. The Dow is used to represent the biggest companies, chosen by Dow Jones to best represent industry.

    Huge companies, like those on the Dow, don’t grow like smaller companies do, and this gets reflected in growth of the stock price.

    The 10%-12% comes from *all* stocks and was first reported years ago by Ibbotson.

  2. Personally I don’t care what the market average turns out to be for the 21st century – I expect to retire by 2030 and probably won’t be alive much into to second half of the century (I’m 46).

    Then again, if medical advances develop some effective treatments for aging, I may need my investments to fund retirement past 100…

    The uncertainty about longevity risk is nothing compared to the uncertainty about any forecasts of market performance by futurists – even one with an investment track record as good as Warren’s. The performance of stock investments will depend largely on overall economic growth. That in turn depends on a whole lot of “big questions” that no-one knows the answers to:
    * what will be the ultimate effects of global warming?
    * what will be the economic costs of reducing CO2 emissions?
    * will fusion power generation turn out to be possible and economic?
    * what unexpected technological advances may happen in the next 100 years – AI, nanotechnology, room-temperature superconductors?
    * what will be world population, life expectancy in 100 years?
    * when will peak oil, peaks in other commodities occur?

    Given the number of world-changing events that could happen in the next 92 years, I suspect that using the past 100-year market average is still as good a guess regarding the future as any other.

  3. Roman says:

    Warren is a realist. Plus there is no way that the market can always grow 10% after a war. This war is not even a standard war that can be over quickly it is long and dragged out.

  4. My god, Enough Wealth … you’re 46, but you LOVE your job that much that you want to work another 22 years (to 68)??? Hell, I’m 49 – already retired – and regret that I didn’t learn what the last 7 years taught me earlier and retire at 29, or 29!

  5. The difference is the Dividend …

  6. I don’t LOVE my job, but it’s pleasant enough work for a decent wage. It also has made me a millionaire, and offers near certainty that I can achieve the goals I have for funding my kids education, my retirement, and leaving a modest estate to my kids.

    In your blog you state you could have stayed in your job until 65 and accumulated $1m as an employee, but you felt the urge to run your own business. In your case it worked out well and you made several millions in a few years and could retire by 49…. well done. But I’m not you. The very fact that I’m still working as an employee (and only vaguely thinking about starting a small business that would be lucky to be worth a million after 5-10 years development) would suggest that I’d probably NOT have made $7m and retired by now if I’d tried to run my own business when I last changed jobs ten years ago…

    I think the point is that almost anyone with a college degree should be able to save and invest enough to have a million by my age (and then either retire early, or choose to keep working if they like their job). On the other hand, your chosen route would probably only work out for a fraction of those who tried to run their own business – the rest would end up going back into salaried employment after a string of business failures.

    People should definitely ‘go for it’ if they think they can make millions running a business — but I really doubt that EVERYONE can succeed at running their own business (even if they try, try again). That’s why I don’t think that route to wealth can be advocated as a universal solution. I think that the safe and boring road to modest wealth with a 90%+ chance of success beats the fast and challenging road to higher wealth that (for the average employee) probably has a success rate of less than 50%.

  7. jim says:

    Enough Wealth: Very true, I think that people often make the mistake of assuming their path is the right path for everyone else and that everyone else can find success in that path, because that’s certainly not the case. There are plenty of professional poker players and, even if I could be a successful one, I’m certainly never going to be able to put in the time to be so and I probably don’t even have the ability to do it.

    As for your statement that modest wealth and 90% chance beats fast and challenging to a higher $ value for wealth, I agree… 90% of the time. :)

  8. Enough Wealth, what you are saying is that $1 Mill. is enough for YOU. No problem … I started a small business and was trundling along quite happily, until I realized that $1,000,000 simply would NOT be enough!

    I dare say this would be the case for most people … so, grow your little business on the side – if it doesn’t work, try again – and INVEST at least 50% of it’s profits in income-producing investments (real-estate would be nice), and I’m damn sure you’ll be retiring earlier, and on much more than $1,000,000, too!

  9. Adfecto says:

    The real return of the stock market is unlikely to keep up with the 10% pace in the way most people assume. The long term return is best approximated by the growth of GDP plus the risk premium (to compensate for the risk of owning equities vs. commercial paper vs. government securities). Using those numbers the return should be more like this (GDP + Debt Risk Premium + Equity Risk Premium – Inflation) 4% + 2% + 2% – 2.7% = 5.3% (Warren’s number). That is what you should realistically expect for US Large Caps. If you branch out into small caps and international equities you take on additional risk and should get a slightly higher return for that additional risk (approximately another 1%). Ditto for adding emerging or developing markets. Thus an equity only portfolio that holds a global index such as the MSCI All World (includes: domestic, foreign, small cap, large cap, & developing markets) can probably still get 10% per year before inflation but about 7% real return after 3% inflation and even less after including taxes and fees (if applicable).


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