Of different places where you can invest your money, the stock market is one of the best. Returns in the stock market for investors in large numbers of stocks through low-cost index mutual funds have been between 10% and 15% annually during long periods of time in the past. There is no reason to believe this will not continue in the future provided the drivers that have caused the growth of the economy, including increases in population and increases in productivity, continue. After inflation, those returns are between 6% and 10% – much better than the 2%-4% after-inflation return you can get from bonds. Those returns aren’t like those from a bank account, however, and new investors must understand this to analyze the risks they are taking on and how to control that risk.
The first thing to understand is that no one knows where the market will be next week, next month, or even next year. No one even knows where the market will be in three years or five years. It might be up, it might be down, it might be at about the same level it is at now. For this reason, the stock market isn’t where you want to be with money you’ll need soon. That’s what bank CDs are for.
Instead, the returns on stock mutual funds move all over the place during short periods of time (a decade or less), but produce reliably positive returns during long periods of time. I liken it to a raging river with all sorts of rapids and eddies. If your throw a stick into this river, you never know where it will be a few minutes from now since it may get caught in an eddy and move upstream or find the current and shoot downstream, but you can be pretty certain that it will be way downstream if you wait an hour or two.
For this reason you can’t simply sit down and type an interest rate into a financial calculator and figure out what you portfolio balance will be next year and the year after. Instead, you must look decades down the road and look at ranges of portfolio values based on probable long-term rates of return. For example, let’s say that you were investing $500 per paycheck in a 401k and wanted to be sure you had at least $2M in your account by the time you retire in 40 years. Over such a long period of time you can safety assume that you would get the market average returns of between 10% and 15%. You would therefore put your $500 monthly contribution into the calculator, set the annual rate of return at 10%, and then see what you would have in 40 years when you were ready to retire. You would also put 15% into the calculator and see what portfolio value you would have after 40 years if you got lucky and got a stellar return. Thsi would give you bounds to the value of your portfolio and you would assume the actual value would be somewhere in between.
I did this using the compound interest calculator found here and got the following results assuming a return of 10% per year:
10% Interest rate, $500 per month
year:account value
1 : 6282.78
2 : 13223.45
3 : 20890.91
4 : 29361.24
5 : 38718.53
6 : 49055.65
7 : 60475.2
8 : 73090.53
9 : 87026.85
10 : 102422.48
11 : 119430.24
12 : 138218.93
13 : 158975.05
14 : 181904.6
15 : 207235.17
16 : 235218.18
17 : 266131.38
18 : 300281.6
19 : 338007.8
20 : 379684.41
21 : 425725.12
22 : 476586.88
23 : 532774.54
24 : 594845.79
25 : 663416.7
26 : 739167.88
27 : 822851.2
28 : 915297.26
29 : 1017423.62
30 : 1130243.96
31 : 1254878.05
32 : 1392562.97
33 : 1544665.29
34 : 1712694.72
35 : 1898319.02
36 : 2103380.61
37 : 2329914.83
38 : 2580170.15
39 : 2856630.46
40 : 3162039.79
Looking at this result, our investor could be pretty confident that he would have at least $2 M at the age of 65 since he would have over $3.16 M with a 10% annual return. Looking at the results from a 15% rate of return, things look even better:
15% Interest Rate, $500 per month
1 : 6430.18
2 : 13894.04
3 : 22557.75
4 : 32614.19
5 : 44287.25
6 : 57836.81
7 : 73564.52
8 : 91820.52
9 : 113011.27
10 : 137608.52
11 : 166159.9
12 : 199301.03
13 : 237769.76
14 : 282422.5
15 : 334253.37
16 : 394416.3
17 : 464250.68
18 : 545311.25
19 : 639402.68
20 : 748619.74
21 : 875393.92
22 : 1022547.63
23 : 1193356.96
24 : 1391624.67
25 : 1621764.8
26 : 1888901
27 : 2198980.55
28 : 2558906.79
29 : 2976692.8
30 : 3461639.8
31 : 4024544.22
32 : 4677938.07
33 : 5436367.92
34 : 6316718.81
35 : 7338590.08
36 : 8524731.77
37 : 9901551.09
38 : 11499700.34
39 : 13354759.31
40 : 15508027.38
Here our investor would end up with about $15.5 M at retirement. (You can see why higher interest rates are not just a little better – they are a lot better, which is the reason to invest in stocks and not in bonds when you have a lot of time to invest.) Based on these results, our investor could safely assume that he would have somewhere between $3 M and $15 M at retirement if he keeps contributing as he has been.
Looking at the results for earlier period, however, would be a mistake. For example looking at the results at 10 years for a 10% rate of return and a 15% rate of return, one gets about $102,000 and $137,000, respectively. While one could reasonably expect a positive return over any ten-year period (virtually every 10-year period has seen a positive rate of return), there have certainly been periods with rates of return considerably less than 10%. One might have $50,000 at that time, or one might have $200,000 at that time, depending on whether several seriously bad market events occur during that period or several really good events occur. If you started investing in the early 1980’s just before President Reagan decreased taxes and unleashed a 20 year period of great prosperity and growth, you might have gotten a return of 15% or more. If you did so in the 1999 and then suffered through the dot-com burst and then the housing market bust, you would have done considerably worse than 10%. The next several years, however, from 2008 to the present, have seen years of 30%+ returns in the market that have caused the rate of return to increase back up to about 10% for the 15 year period.
So, while it is safe to assume returns of 10-15% for long periods of time, like many decades, and it is safe to assume you’ll get a positive return if invested in index stock mutual funds for a period of 10 years or more, it is not safe to assume 10-15% returns for periods of 10-20 years. The lesson is to start investing early for retirement so that you can catch the boom times whenever they occur during your lifetime. You just don’t know when they are going to be, so waiting until you are 50 and trying to play catch-up, hoping that 15% returns will allow you to meet your retirement goals, isn’t a good plan.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.