Someone who reads my blog emailed me this question:
"What kind of a long-term annualized return should an investor…expect to earn in stocks over the course of his lifetime and why? When, where and how should bonds or other liquid securities besides stocks be included in the portfolio? How does this expected return compare to other reasonable alternatives the everyman might consider, and what are some of those alternative investments (i.e., rental real estate, a small business, etc.)? Should most people just humbly manage their stock portfolio as advised, or is stock investing really NOT for the average person despite the industry support for it?"
This is an easy question to answer theoretically. It is a harder question to answer practically. But, start with the theoretical. The return an investor will get in something like the S&P 500 is going to depend on the price these stock purchases are made at, the return the companies get on their own money and frictional costs (the taxes you pay, the fees you pay, etc.). Price is very important in the short to medium term. So, what you earn over the next five to 15 years is going to largely depend on the price you buy in at and whether interest rates rise or fall while you are invested.Say an investor is buying the S&P 500 today at a Shiller price-earnings (P/E) of 27. I would expect interest rates to tend to rise more than they fall over the next five to 15 years (since they have tended to fall more than they have tended to rise for several decades now) and that will cause the Shiller P/E ratio to contract. The long-term average might be something like 15. So, say we will see a contraction from 27 times normalized earnings to 15 times normalized earnings over the next 15 years. That is 27-15 = 12. And then 12/27 = 44%. So, you have a 44% contraction in the Shilller P/E ratio. This is not a lifetime thing. It is a short-term thing. But, it is why I would say that over the next five to 15 years you can expect returns in the 5% to 6% range instead of returns in the 8% to 10% range or whatever it is investors have been accustomed to.
Assume you buy stocks at a normalized P/E of 15 instead of today’s Shiller P/E of 27. In that case, the theoretical long-term return is easy to calculate. It is the change in the company’s size – sales, assets, etc. – and the payout (stock buybacks and dividends). As a rule, existing companies (since they are big) do not grow sales, assets, profits, free cash flow, etc. any faster than nominal GDP. So, imagine the U.S. population will grow 1% a year, real output per person will grow 1% a year and inflation will be 3% a year. In that case, nominal GDP would grow by 5% a year (1% plus 1% plus 3%). The S&P 500 has a dividend yield of about 2% right now. If you bought the S&P 500 today and then U.S. nominal GDP growth was about 5% a year while you owned the S&P 500 – you could expect a return of about 7% a year. Like I said, this is complicated by the starting and ending price of the market when you buy and sell. But, over very long holding periods – this is not very important.
I used an approximation here. It does not really matter what the dividend yield is. What actually matters is the amount of earnings a company does not reinvest in the business. In other words, what does the S&P 500 as a group earn that it does not reinvest in the business – but instead uses to pay down debt, pile up cash, buyback stock or pay out dividends. Paying down debt now means it can add debt later. Piling up cash now means it can grow its payouts faster than its earnings in the future. Buying back stock increases earnings – and dividends – per share in the future. And paying out a dividend gives you a dividend. So, it does not really matter what the dividend yield is. What matters is the amount of earnings the company is not reinvesting in the business as a percent of the price you are paying for the stock. Historically, U.S. stocks were often priced to pay a dividend yield of about 3% while buying back no net stock and growing about 6% a year. In the future, assume the average U.S. business will retain half its earnings and use the other half for share buybacks and dividends. If the Shiller P/E is now 27, that means the Shiller earnings yield is now 3.7%. So, the normal expected payout would be about 1.85% of the share price in stock buybacks and dividends. The growth in that payout would be about 5% a year. On a normalized earnings basis – and assuming 1% population growth, 1% real output per person growth and 3% inflation – we would expect about a 6.85% return in the S&P 500, if you never sold it. The sooner you sell it, the worse your return is likely to be. This is because the S&P 500 is overvalued right now. You can expect to sell stocks at a lower P/E multiple in the future than you are buying them at now. Multiple contraction is very important in the short term. It is not important if you are going to hold stocks for 30-40 years. If someone is 25 to 35 years old now and they are wondering what kind of return they can expect in stocks – then their holding period should be 30 to 40 years. That is, they should be a net buyer of stocks till at least age 55 to 75. I think someone who is that young and is investing in something like the S&P 500 right now can expect a return close to 7% a year. Historically, U.S. stocks have done a lot better than 7% a year. So, most experts are going to suggest a higher number. For that reason, I will not argue if someone says you can “count on” 7% annual (nominal) returns if you buy an index fund today and hold it for most of the rest of your life. The more important figure is about a 4% real return. To get that, you need to not trade stocks though. You cannot sell stocks and pay taxes along the way. That would erode much of your return because the taxes are paid on your nominal gain – not your inflation adjusted gain. So, tax rates as a percent of your real gain are big. Say you make 4% a year in real terms over the next 10 years. You invest $10,000 today and have $14,800 in real purchasing power at the end of 2026. However, taxes are paid on the nominal amount of your gain – not the real amount. Your nominal return – in a 3% inflation rate world – would be 7% a year over 10 years. So, your account would show more like $19,700 in it at the end of 2026. If you sold everything you owned after 10 years and paid a 15% capital gains tax, you would have just $18,245 left over. See how you are paying 15% of $9,700 instead of 15% of $4,800? You do not really have a gain of $9,700. You only ever increased your wealth by $4,800. So, the tax you are paying on the real increase in your wealth is a lot higher than you might think at first.
It does not matter if this is taxes or fees, indexes can work. I believe it can grow your real wealth by 3% to 4% a year for 30, 40, even 50 years. But, there are a lot of different problems that can arise and erode a lot of this. These are controllable problems. You can just consistently put money into the lowest cost index fund you can find and never sell that stock. You can never trade. You can never invest in any other asset classes. If you do that – and almost no one does, or ever will – you can grow your wealth by 3% to 4% a year in real terms. There is little risk in this. Owning stocks is risky over the next year, five years, etc. Owning stocks is not risky over any 25 to 50 year period. In terms of preserving your real wealth, stocks are always going to be a safer bet over a quarter century or half a century than anything else. But there is not going to be a very big margin of safety in terms of taxes, fees, time spent out of the market, etc. A 3% to 4% annual real return is not a lot to cover the mistakes that investors will make when investing in an index fund. So, they can quickly squander that advantage by paying more in taxes and fees than they need to and by timing the market in such a way that they lose money.
I think investors in an index fund – who do not do anything but add to that index fund over their lifetime – can expect a 7% annual return in nominal terms and a 4% annual return in real terms. I do not think they should expect to do better than that. I think their actual experience – in their own account – will tend to be worse. They are not going to add consistently to that index fund without ever selling, moving their money elsewhere, etc. for 30-50 years. So, they are going to pay some taxes and fees. They are going to make some mistakes – like timing the market incorrectly – that are going to lower the performance of their account below the performance of the index fund they picked. Therefore, I think about a 7% annual return in nominal terms and a 4% annual return in real terms is more of a ceiling on a passive investor’s performance than the level they should actually expect. If you put all your money in an index fund, you should expect your actual wealth to grow somewhat slower than 7% a year in nominal terms and 4% a year in real terms.
That does not sound that impressive, but it is better than what a “know-nothing” investor could expect in any other asset. We are talking about the possibility of unleveraged returns of 4% a year over infinitely long periods of time. Someone with no special knowledge and no active participation in the running of their portfolio is not going to make 4% a year real over their whole lifetime in any other kind of asset. Real estate does not offer 4% real returns without the use of leverage. Bonds do not offer 4% annual real returns at all. Yes, businesses can generate better than 4% annual real returns, and they do. But only if they survive the first few years that eliminate most businesses. Small businesses do not really offer better returns than publicly traded stocks. Publicly traded stocks offer great returns for the winners – the best in class stock pickers. And small businesses offer great returns for the winners – the best in class competitors in their industry, their town, etc. The downside in a small business is even bigger than in the stock market. So, I do not see anywhere else that an investor can be truly passive and expect returns of nearly 4% a year in real terms.
So, no, I will say that the average investor should not consider any other type of asset other than common stocks. I do not think individual investors should include gold, corporate bonds, Treasury bonds, etc. in their portfolio. I do not think they should own real estate. If you already have a house – you should not be invested in real estate. Your own home is a huge asset relative to your net worth. It is highly leveraged. Now, the financing is very, very attractive. So, I am not saying that people should not take out mortgages and buy homes. I think they should. It is just that once you own a home, I do not think you should ever have anything else to do with real estate. The average American already has too much money in real estate through home ownership.
My advice is to always have 100% of your money in some combination of stocks and cash. For the portion that is in stocks, you should expect about a 7% annual nominal return – or 4% real return – plus or minus whatever your skill adds or detracts from your investments.
Disclosure: No positions.
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