Don’t plan for a 12% return (but earn it anyway)

Photo courtesy of cotinis

 

WARNING: This post contains math.

How much return do you expect to make on your stock market investments? (Don’t say zero.)

There are those who will say that you can expect to earn a 12% return on your investments over the long term. This isn’t to say that you’ll make 12% this year, or next year, or even on any year, but over your life, with a good year here and a bad year there, it will average out to 12%.

I’ve seen a lot of these claims, and my goal is not to prove or disprove them. More important, though, the 12% claim is largely irrelevant for how to plan your investment strategy.

The 12% solution

Play with this calculator for a while. It shows the “compound annual growth rate” (CAGR) for the S&P 500, a broad-based subset of the stock market.

Click here to see how the S&P 500 performed.

Click here to see how the S&P 500 performed.

Plug in two different years and see what the average annual return between those years are. Here are a few sample answers I found:

  • 1871 to 2013: 9.07%
  • 1921 to 2011: 10.39%
  • 1932 to 1999: 12.66%
  • 1978 to 2013: 11.85%

(Notice there are two different percentages listed on that page. The CAGR is really the only one we need to concern ourselves with right now.)

I couldn’t find a long period of time that was any less than 9%, and most of them were in double digits. So indeed, it seems that over a long term, you can get close to 12%.

I don’t care. And you don’t want to care either.

Intentional “mis-estimation” for fun and profit

Here’s why. I’m a big fan of the motto “under-promise and over-deliver.” So, when planning, I like to assume that things will cost a bit more than they do, that I’ll make less than I actually do, that things will take longer to accomplish than they actually do, etc.

The reasoning for this is both emotional and practical: conservative estimates give you room for error and the unexpected.

Let’s say that you’re forced to run an errand that involves going to a store and buying something. You estimate that it will take you two hours to do the round trip. Do you plan something for exactly two hours after the moment you leave? What if the bus breaks down, there’s crazy traffic, the store is closed, they are out of the item and you have to go somewhere else, etc? I would pad my estimate and not plan anything until at least three hours after, possibly more.

The same goes for investments.

The dangers of numerical overconfidence

Let me show you an example of why it pays to not be overconfident.

Let’s say you have figured out that you need to eventually have $1,000,000 in retirement. Let’s also say that you start with a balance of $0.

According to this ROI calculator, you will need to save $3,700/year ($308/month) in order to accomplish this goal. If you have 40 years, this goes down to a relatively painless $1,200/year.

But that is assuming a return of 12%. What if your investments only make 9% and you planned for 12%?

On the 30 year plan, you’ll have saved only $550,000. On the 40 year plan, you’ll have saved only $440,000. Either way, it’s going to be a problem.

The benefits of numerical cautiousness

Now, let’s say that you plan for a 9% return. To get $1,000,000 in 30 years, you’ll need to sock away $6,700/year ($560/month), a little less than double. For 40 years you need $2,700/year.

Time out: For a measly 3% difference in return, you basically need to spend double to compensate! So never forget that a little difference in return makes a huge difference over the long term.

So here’s the fun part: if you plan for 9%, and you make 12%, then on the 30 year plan, you’ll have $1.8 million. For 40 years, $2.3 million! Wow!

Click here to play with the ROI calculator. As Levar Burton said, "don't take my word for it."

Click here to play with the ROI calculator. As LeVar Burton said, “don’t take my word for it.”

Which outcome would you rather plan for?

Real hope is better than false hope

But I can’t put that much money away!

My first knee jerk response is: “you must find a way; you don’t have a choice.

And sure, there’s a tendency to look at these numbers and think that you’ll never be able to achieve them. That you’re going to get to retirement age with $10,000 in the bank and some dusty student loans.

But I think it’s much more dangerous to have a false sense of security. I can’t imagine working up a plan and sticking to it for years, only to watch with increasing dismay and panic as it under-performs. Compound interest is your friend, and if you wait to put away more, you’re just going to make it harder on yourself later.

So find a way to start now, or soon. Start small, and work your way up. However you do it, plan for something less than optimal. If you’re right, you’ll be fine. If you’re wrong, you’ll come out way ahead. That’s some good odds.

But enough about me: What kind of returns do you plan for?

A bit more about me: You know you can Ask me anything, right? If this brought up some questions that you want to discuss, let me know!

Mike Pumphrey

Mike Pumphrey

I'm the founder and author of Unlikely Radical, a site to help people succeed with money, achieve their goals, and live intentionally.

I offer a free phone consultation to anyone who is interested in changing their financial narrative. Are you ready? Click here for details.
Mike Pumphrey
Posted on August 18, 2014