Those of you, who know me well, know that I am not a fan of predictors or pundits who predict the future. However, I do think it is a totally rational concept to be able to come up with a realistic range of returns for investments over the long haul. To do that, we can use history and observations of the present and prospects for the future.

I was literally shocked yesterday to read that the annual survey of global investors by Natixis Global Asset Management showed that investors need an annual return of 9.7% per year above inflation to meet their long term goals. Additionally, 84% of them said they would choose safety over high returns. While they may achieve their goals (9.7% plus inflation) over a short period of time, their chance of long term success is ……..approaching zero. This return is not a sustainable one as we will show below.

First, let’s start with a quick look at history and what returns have provided in the past. From 1900-2014, the S&P index of stocks (500 large company stocks in an unmanaged index) returned about 6.5% after inflation. About two thirds of that return came from dividends and the reinvestment of all dividends. That return is just about 50% less than investors say they now need to have in returns in order to fund their goals. Unless I am missing something huge about the future, there seems no reason to think and assume that the future will be a total break from the past. Many very bright investment minds think future returns will be lower than the past rather than higher. Their reasoning may have merit, but we shall ignore them in our calculations below.

To look at the future prospects for investments, the beauty of Ed Easterling’s financial physics makes it simple to understand where long term returns must come from. The first area of returns on investment is earning growth. GDP (Gross Domestic Product) growth over the long haul tends to be about three per cent per year and fairly consistent. You can argue that operational efficiencies can help earnings growth outpace GDP growth. So, let’s generously allow a range of returns of 3-6% from earnings growth. The actual return without dividends of the S&P since1900 is 2.14%, so we are being quite generous.

The second area of returns is dividends.  The long term average for dividends is about 4.3% per year. Currently, the dividend rate is below half of that figure. Again, let’s be generous and assume that somehow we may get back to that average rather quickly without valuations of stocks dropping dramatically. So, for dividends, we have a range of 2-4.3% to add to our investment returns.

There is only one more place that returns can come from. That place is the area of valuations (Price to Earnings expansion or contraction).We can make or lose money by “Mr. Market” paying us more or less for a future dollar of earnings. While global prices for stocks may be near average, they are clearly above average in US stocks. So, investors are currently paying more than normal for a dollar’s worth of future earnings. We are more likely than not to see that return towards average in the future, which will be a headwind for future returns. Out of our continued generosity, let’s just assume that the long term future return from valuation of investments will be zero.

We now have a range of returns for the long term future returns from above of 5-10.3% (Earnings growth plus dividends plus change in valuation).  Now, we must subtract inflation from this figure to arrive at a realistic long term range of returns. Since the Fed targets a 2% inflation rate and the long term historic rate is 3%, we can make our long term rate of inflation 2-3%. That leaves us a range of long term returns for the future at a low of 2% per year and a high of 8.3% per year. The midrange of this range of potential outcomes would be just under 5.2% per year.

Remember that our investors overwhelmingly indicated they were choosing safer investments (I.e. accepting lower returns for less risk).  Given that fact and the fact that they need 9.7% per year in long term returns, it is clear that they must return to the drawing board.  They have assembled a plan that is not capable of working. There is no math that will allow you to earn 9.7% per year plus inflation over the long haul. Then, add the increased emphasis on safety plus…we have not included any cost for managing and maintaining your investments (the trading costs, management fees, fund expenses, etc.). These further reduce the range of returns above. The solution to this dilemma must start with realistic ideas like increasing your savings rate rather than merely hoping for pie in the sky returns.

By Ted Schwartz, CFP®