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Myths - 12% Investment Return

I have seen some financial advisors suggest a 12% return as a reasonable projection for future investment returns. Due to the stock market decline in 2000, 2001, and 2002, many advisors are starting to suggest a lower rate. The expected return rate that advisors suggest is usually tied to historical returns of the stock market or the previous performance of their investment selections. Either way, there are two factors that are usually overlooked which may reduce your investment rate:

Geometric average vs. arithmetic average

When reviewing the historical returns, if the source of the information is based on the simple arithmetic average, it is probably too high because lower returns have more of an effect on your portfolio than higher returns. A geometric average factors this in to get a reasonable long-term growth rate. For example, in a 2-year return scenario:

Year 1 & Year 2 Returns

$10,000 Investment Grows to

Arithmetic Average

Geometric Average

9% & 9%

$11,881

9.0%

9.0%

0% & 18%

$11,800

9.0%

8.6%

-9% & 27%

$11,651

9.0%

7.9%

As you can see, even though each of the three examples generated an arithmetic average return of 9%, the actual investment grew at different rates over the 2-year investment period (7.9%, 8.6%, and 9.0%). As shown in the last example, the $10,000 investment at a 7.9% return would grow to $11,651 at the end of two years. If you assume the 9% return, the assets would have been projected to grow to $11,881 (2% higher than what actually happened). This may sound like a small difference, yet over a 30-year period, your estimated assets could easily be off by over 30%. Due to variability in the stock market, there is typically a 1% difference in the two averages. So if your advisors say they can get you a 12% return based on their past performance, find out if they used a simple arithmetic return or if they calculated it the more accurate way using the geometric average.

Investment management fees

Even though many financial institutions are using the geometric return properly, they may not be adjusting their projected returns by their management fees. Fees can be as high as 2.5% to 3% in some cases. Even with exchange traded funds (ETF) and mutual funds, the fees can average around 0.5% to 1.0%. This means for a 1% investment management fee over 30 years, would result in your expected assets being 30% less than expected.

What has been the historic return of the stock market?

Based on a study from Mellon and Ibbotson Associates at the end of 2003, the stock market has historically generated the following average returns:

	Last 78 years	Last 50 years	Last 20 years	1984-1998	1999-2003
S&P 500	10.4%	11.7%	13.0%	17.9%	-0.6%
Mid Cap	11.3%	13.1%	12.6%	14.8%	6.3%
Low Cap	11.7%	13.6%	12.3%	13.2%	9.7%

Looking at the last 78 years, the historical returns would suggest using a 10.5% to 11.0% rate to project future returns. With investment management fees of 0.5% to 1.0%, this would suggest a 10% return (or lower if you want to be conservative). However, this is based on equities only. So when estimating the return in your investment, you should consider that you are probably diversified and are not invested 100% in the stock market. Thus, you should factor in returns of other investments that have lower returns like bonds and cash. For example, if you are 65% in stock which are expected to return 10% and 35% in bonds which are expected to return 5.5%, your average return would be:

Equities (10% X 65% = 6.5%)	6.5%
Bonds (5.5% X 35% = 1.9%)	1.9%
Total	8.4%

This is why I suggest using a lower rate when projecting your retirement savings, even though the starting point for some websites is 10% to 12% return. Using a lower investment return is also supported by many large companies who are projecting 8% to 9% long-term return on their pension assets.

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