Monday, January 11, 2010

Another Look at the Risks of Planning Retirement Based Upon Average Stock Market Returns

In a recent post we reviewed the range/variability of stock market results over 20-year periods, and the likelihood market returns would fall above or below specific values. For example, how often have returns fallen below 6%? In this post, we'll do the same with 10-year returns.

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 10 Years

Retirement Savings: Distribution/Variability of 10-Year Returns

The graph above (click to expand), illustrates the historical results of investing \$100,000 in the Dow Jones index for 10 years. In the example, we're supposing a 55 year old who receives a \$100,000 windfall and is planning to retire at age 65. (Note: to calculate ending portfolio values for an investment of \$1,000, divide 100. To calculate the results for n thousand dollars, multiply the results for \$1,000 by n. For example, for a \$25,000 investment, multiply the results for \$1,000 by 25.)

For this theoretical analysis we're assuming the money is invested tax-free, and with no commissions or management fees. The results shown are based upon my DJIA (Dow Jones Industrial Average) database; 10-year returns beginning end-of-year 1899 through 2003 are included. The interpretation of the lines in the graph is as follows:
• The "average returns" line shows the result of \$100,000 invested at 10% -- the approximate average 10-year return in my database ; the value of the retirement portfolio at age 65 is about \$259,000. This is the top of the dark green section of the chart.
• The "50% Chance" line ends at \$241,000. This means 50% of the time \$100,000 invested for 10 years resulted in an ending portfolio of at least \$241,000. This is the top of the lighter green section of the chart.
• The "67% Chance" line ends at \$200,000. This means that 67% (i.e., two thirds) of the time \$100,000 invested for 10 years resulted in an ending portfolio of at least \$200,000.
• The top of the dark red section is the "worst-case" scenario. It shows that 100% of the time the result was at least ~\$88,000. Note that in the worst case the investor ends with less than he started with!
See the appendix at the end of the post for a graph of year-by-year values.

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

The fact that the graph in the 10-Year Rolling Returns post goes up and down makes it clear that investors do not always get average returns. As we saw in the last post, if history repeats itself, the investor is not likely to reach his target if he plans on average returns. To have a 50-50 chance, he would have to plan on \$240,000 instead of \$260,000. Following is a table to help you approximate the returns you might receive. (Note: percentage results are the same regardless of the amount of the initial investment.)

10 Year Stock Market Return Probabilities

The interpretation of the numbers is as follows:
• Historically, there has been a 50% chance of 10-year returns equaling or exceeding 9.2%; and a 50% of their being less than 9.2%.
• There has been a 67% chance of returns equaling or exceeding 7.2%; one in three times they were less than that.  Since 33% of the returns are below this point, it represents the 33rd percentile.
• etc.

Using 10-Year Stock Market Return Percentiles with Retirement Calculators

The table above is probably most useful if you are about 10 years from retirement and are using a retirement calculator to estimate how much money you will have when you retire. In that case, you could run multiple cases -- e.g., a 67% case, an 80% case, and a worse case to get a feel for the possible outcomes.

Bottom line: If you're comfortable with a slightly less than 50-50 chance of reaching your retirement goals, you can plan on average returns (minus commissions, fees, etc.) for the stock component of your retirement portfolio. Otherwise, consider making more conservative assumptions.

Finally, note that if you're uncomfortable with the spread between the best case and the worst case (in dollars), you can often reduce that spread by reducing your allocation to stocks. This will generally improve the worst case -- but at the cost of reducing the best case.

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Related Posts

Variability of 10-Year Market Returns, in Dollars: Similar to this post, but focuses on dollar impact. Many find that graph easier to understand than this one.
Retirement Planning: Distribution/Variability of 20-Year Stock Market Returns: similar to this post, but for 20 years. Includes the probability table and a more detailed description and explanation than this post.
Distribution/Variability of 20-Year Stock Market Returns II: A slightly different take on the variability of 20-year results. Not as complete, but some find that graph easier to understand.
Range of Stock Market returns in Dollars for 10-100 Years: Bigger picture. Shows the best and worst outcomes for other time periods as well.
Rolling 10-Year Stock Market Returns covers all 10-year periods.
The 10-Year Market Projection: I also use this projection to adjust my expectations for future returns.

For a list of other popular planning posts, see the sidebar on the left.

Appendix

Following chart shows the probability of reaching various levels of accumulated savings by year.