Observations: Don't Plan Retirement Assuming Average Stock Market Returns

Planning Your Retirement Assuming Average Stock Market Returns is Risky

In a recent post I warned that developing your retirement plan based solely upon the advertised average stock market returns may be hazardous to your financial health. When using a traditional retirement planning calculator, I consider not only the average but also the range of past outcomes, and the distribution/variability of returns between the best and worst outcomes.

Note: If you find the chart below difficult to digest, see the presentation in this post first.

Historical Results of Investing in the Stock Market for 20 Years

Retirement Savings: Distribution of 20-Year Returns

In the chart above (click on it to expand), we revisit the situation introduced in the previous post -- you receive a $100,000 inheritance at age 45 and plan to retire at age 65. (Note: to calculate results of a $10,000 inheritance, divide by 10.) The point of the chart is to give you a better feel for your potential results based upon the historical results in my database of DJIA (Dow Jones Industrial Average) stock market returns over the past 100 years or so. The interpretation of the "lines" is as follows:

The "average returns" line shows the result of $100,000 invested at the average 20-year return in my database; the value of the retirement portfolio at age 65 is about $673,000. This is the top of the dark green section of the chart.
The "50% Chance" line ends at $637,000. This means 50% of the time $100,000 invested for 20 years resulted in an ending portfolio of at least $637,000. This is the top of the lighter green section of the chart.
The "67% Chance" line ends at $475,000. This means that 67% (i.e., two thirds) of the time $100,000 invested for 20 years resulted in an ending portfolio of at least $475,000.
The top of the dark red section is the "worst-case" scenario from my previous post. It shows that 100% of the time the result was at least ~$164,000.

Note: see appendix at the end for a graph of year-by-year results.

The Probability of Achieving Average Stock Market Returns is Less Than 50-50

First of all, note that, if history repeats itself, you're not likely to reach your target if you plan on average 20-year returns! Your chances are less than 50-50. To have a 50-50 chance you'd have to plan on having $637,000 instead of $673,000. But, do you really want to plan to have only a 50-50 chance of achieving your retirement goals? I think not.

What's Going On Here?

The average summarizes about 90 20-year periods in stock market history. Stock market history includes many 20-year periods that would result in the theoretical retirement portfolio being significantly more than your planned $673,000. In the best case, 1979-1999, you would have retired with over $2.7 million! In calculating the average, these above average returns offset the below average returns. If we wanted to estimate the returns of thousands of people investing at many different points in time, the average return would be a good place to start. However, we're assuming you only get your $100,000 inheritance once. If you invest it in a year that yields 2.5% returns, you're not likely to be consoled by the fact that investing it under different circumstances might have yielded a 15% return.

As a result, when I'm using traditional retirement planners, I run them several times in order to develop multiple cases assuming various levels of stock market returns (see the table below).

Stock Market 20-Year Return Percentages

Table of stock market (Dow) return percentiles (probability/chance return will be more/less than x percent)

Like all published stock market returns, these results are theoretical. Factors such as taxes, transaction fees, mutual fund management fees, etc. normally reduce the results in the real world. In addition, these results are approximate -- they are based on fewer than 100 data points. The interpretation of the numbers is as follows:

Historically, there has been a 50% chance of 20-year returns equaling or exceeding 9.7%; and a 50% of their being less than 9.7%.
There has been a 67% chance of returns equaling or exceeding 8.1%; one in three times they were less than that. Since 33% of the returns were less, this is the 33rd percentile.
etc.

When returns are less than plan you won't have as much money to spend as you planned; sometimes the "less than plan" results were much less than plan.

Using 20-Year Return Percentiles with Retirement Calculators/Spreadsheets

I think 20-year return percentiles are especially interesting since they can be used for planning results from age 45 to 65 (a typical planned retirement age), and also from age 65-85 (the minimum age at which I end my plans). One way to use the table would be to use a traditional retirement planning model, such as the spreadsheet I introduced in October, and run multiple cases -- e.g., a 67% case, an 80% case, a 90% case, and a worst case. If planning based on the 80% case (6.9% theoretical stock market returns) seems ridiculously conservative to you, don't forget that 20% of the time (one of every 5 times) the results would have been worse than that -- sometimes much worse.

Note that these results assume a constant annual rate of return. That's okay in this case since there are no periodic additions or subtractions to the investment portfolio. Annual or monthly additions or subtractions would change the results, but not invalidate the basic point.

Doing this exercise may encourage some people to reduce their dependency on stock market returns -- especially in or near retirement. You might, for example, trade off the possibility of retiring with much more than you planned for reducing the probability that you will retire with much less than you planned. This is typically accomplished by increasing your allocation to fixed income investments, and/or increasing your guaranteed retirement income (from social security, pensions & annuities).

Finally, note that these are not the only reasons to plan on less than average returns. For example, my P/E vs Future Returns and Projecting Market Returns posts at least suggest that I'm not likely to achieve average returns if my plan is starting when the market is richly priced. As a result, if I think normalized P/E ratios are high, I'm more conservative.

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The Distribution/Variability of 20-Year Stock Market Returns: Another look at the variability of 20-year returns. Many find the graph in that post easier to understand than the graph above.
10-Year Stock Market Return Probabilities: same as this post except for 10 year periods.
Why Investing in the Stock Market for Less Than 5 Years is Risky: similar to this post, except for 1 & 5 years.
Range of Market Returns in Dollars for 10-100 Years: A broader view. The current post is an expansion of one bar in this bar chart.
Retirement Calculator/Spreadsheet: a traditional retirement planner.
20-year Rolling Stock Market Returns: a graph of all 20-year returns in my database.
Rolling Returns vs P/E Ratios shows the normalized P/E ratio associated with each 20-year return.

The Stock Market Analysis Spreadsheet introduced in this post can be used to do additional analysis.