How Much Real Return Would You Need?

Last week I came across a poll on Twitter, posted by Meb Faber, Chief Investment Officer of Cambria Investment Management. He asked the following:

“You’re offered an investment that will have 40% loss at some point over 10 years. What yearly real return do you require to accept?”

The possible answers were 2%, 4%, 6% and >8%.

Although the question never mentioned, I immediately thought that it refers to stock returns.

The historical real return of US stock market is around 6.8%. But nowadays you hear it from more and more sources that in the foreseeable future investors should get used to lower (around 4%) real returns.

If you follow my monthly financial updates or you check my portfolio, you will see that I mainly invest in stocks. Also in the last part of my Searching for the Perfect Portfolio series I made the conclusion that at least in the beginning of my FIRE journey I should overweight stocks in my portfolio.

Based on the above, and the fact that a 40% fall in stock prices sometimes within the next 10 years is a very likely possibility, I voted 4% without hesitation. At the end of the day: If I cannot accept such returns, what am I doing in the stock market?

When I saw the results of the poll, I was a bit shocked. 68% of the people who answered required over 8% returns and 2% of them would be happy with 2%.

I thought that both are insane answers. 8% is much more than the historical average, while the prediction is that actually we should get prepared for lower returns. Furthermore those who voted for 2% should rather check the bond market based on my initial view, most likely without the danger of a 40% pull back. Are 70% of the investors this crazy…?

From the other two possible choices 24% voted for 6% and only 6% for my 4% required returns.

Thinking a Bit Further

This has made me think (maybe I’m not confident enough 🙂 ). Is 4% a reasonable, and most importantly sufficient expectation? As FIREcracker from Millennial Revolution would say: Let’s math this shit up! 🙂

math-this-shit-up

First of all let’s forget about inflation for a while, just to make things a bit easier. Also, I take the assumption that the 4% is the average yearly return INCLUDING the year when we have the 40% loss.

The math is actually really simple:

x9 x 0.6 = 1

With some rounding, x would be 5.9%, so you would need this much return over those remaining 9 years just to be break even.

The returns of the positive years over the 10 years period should be calculated like:

x9 x 0.6 = average return10

So x under the 4 possible options would be:

2% – 8.2%

4% – 10.55%

6% – 12.92%

8% – 15.29%

As you can see, in almost all cases we need double digit percentage growth in order to compensate the 40% loss.

Of course if you invest all your money at once, it doesn’t make a difference. You will have the same return, irrespective from the stock market movement over the years.

But if you’re investing continuously, due to dollar cost averaging you will be able to use the stock market fall for your benefit. In this case you will purchase for lower prices during “bad” times. This is even more true if you have spare cash or other assets (e.g. bonds) to reallocate those into stocks.

Actually the earlier the stock market crash happens, the better it would be for me (and for every investor in, a wealth accumulation stage). This is also demonstrated with sample portfolios in the Searching for the Perfect Portfolio series.

In addition, such big drops in the stock market is not extraordinary. Still, over the long term stocks are the assets that historically have provided the highest returns.

Related post: Are Stocks Risky? – History Answers

Stable, dividend paying companies will be able to provide extra value in such times. They will keep on being a source of passive income, while due to the lower share prices they will offer higher yields on new purchases.

Conclusion

Based on the above I am happy with my initial choice of 4% expected annual real return. 6% would be a very-very optimistic scenario considering the current stock market valuations, while over 8% yearly return is extremely unrealistic in my view.

What I see differently now is that I don’t consider 2% yearly return (in case of a 40% drop within 10 years) as such a bad deal. Still it might have sense to move a little bit closer to my initially planned 80% stock 20% bond allocation, just in order to have more ammo if I need to reallocate assets in case stocks will get cheap again.

What do you think of the above? How much real return would you personally expect in case a 40% market drop within the next 10 years was granted?

 

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Disclaimer: This post or any other information on the site is not intended to be and does not constitute financial advice or any other advice. I am solely sharing my idea, plan and progress on financial independence and early retirement.

 

 

 

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