I recently received an email from a reader asking for my advice on trading. He was looking for “a successful trading technique with a good shot at beating the market.”
My reply–and this won’t surprise regular readers–was to ask what reason he has for thinking that an individual investor can reliably outwit the professionals.
His answer: I need a 12% return in order to retire on time. So normal market returns probably won’t cut it.
The Market Doesn’t Care.
Unfortunately, the market doesn’t care that you need a reliable 12% annual return in order to make your retirement plans work. Your need for a given return doesn’t increase your probability of getting it.
To use an analogy: “Going 60 mph won’t get me to work in time” is not a good reason to drive 120 mph. Similarly, “normal market returns aren’t good enough” isn’t a sufficient reason to try to earn above-market returns.
If you have no reason to think that you have a meaningful advantage over the professionals–and I would argue that most investors do not–then the only reasonable answer is to adjust your plans. Figure out a way to make your life work with market returns, whether that means retiring later, working part-time, or cutting your expenses.
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Mike,
You have a great point, the averages are what they are… wishing for them to be higher won’t make it so. Small cap and foreign stocks have both a higher volatility and higher expected returns than US large caps so he could add a small cap and a foreign stock allocation to his portfolio. However that isn’t likely to give the 12% he claims to need.
It sounds like he used some retirement calculator and is now panicking. There is some good new though- there isn’t a magic amount required for retirement! He could reduce his expenses to lower his required number.
He could move to an inexpensive part of the country, get a smaller home that requires less heating and cooling costs, or take up a hobby that could bring in some income.
-Rick Francis
I like how he emailed you of all people, as if there’s any doubt what kind of response you’d give. That suggests to me that he cast a rather wide net to find somebody who will promise him a 12% return, if only he follows a ‘system.’ Unfortunately, he should have little trouble finding such an individual.
“That suggests to me that he cast a rather wide net.”
Hehe. I’m sure you’re right. I figured the message was likely lost on him, which is why I thought it might be worthwhile to bring up here.
Not only can he not expect a 12% return from equities, but it is unlikely that his age warrants a 100% equity allocation (if any age really does).
I hope he emailed Dave Ramsey, Iam sure he(Dave) would be glad to make him “rich” with his great investment advice and all.
While I’m not a proponent of index investing, I do agree with the answer you’ve provided the reader! Sure hope you can do a follow-up with the reader in a few years.
Just realized that you didn’t mention increasing the income (getting a raise, 2nd job, etc.) as a means of reducing the need for increased return. If he really needs that return, then working hard is a legitimate substitute.
These comments have made me curious as to the % return someone should expect to receive on an equity heavy indexed portoflio? I am fairly new to the investing landscape, 26 years old, and I put most of my money into a vanguard 2045 target fund.
Would assuming an 8% return over the period where the fund is 90% equities (about 17 more years in my case) be a reasonable assumption?
Hi Rob.
My best guess for long-term stock market returns is to use the Gordon Equation (more on that here), which basically says to add the inflation-adjusted earnings growth of the stock market to the market’s current dividend yield.
At the moment, using an earnings growth figure of 2-3%, that would give an inflation-adjusted return somewhere in the 4-5% range. Of course, it’s important to note that this is an extremely rough estimate, which only takes on the slightest semblance of accuracy when we look at very long periods.
Thanks for the info Mike. I always find you to be extremely helpful. Now, if I am undertanding your response (and the link you posted) correctly…
It sounds like you are taking this 4%-5% inflation adjusted (earnings growth) return and adding it to a dividend yield that must be around 3% or so? This is how you end up with an estimate of 7.5% to be used for projection?
I also assume this estimate is meant to be the entire equity market (a portoflio only invested/weighted appropriately in all stocks and nothing else) before any additional fees and expenses are calculated?
Actually, I was using a 2-3% inflation-adjusted earnings growth, and adding it to the current dividend yield, which–according to Yahoo anyway–is 1.79%. End result being a total inflation-adjusted return of roughly 4-5%.
And yes, that would be for the total U.S. stock market, as measured by Vanguard’s Total Stock Market ETF. And you’re correct: it’s before expenses.
Rob, here’s a great resource for carefully-forecasted long-term returns. I believe Rick Ferri (A CFA who writes, among other things, a great book on asset allocation) updates it every January.
http://www.portfoliosolutions.com/f-13.html
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