What’s the stock market going to give you if you invest today and hold for 40 years?

Investing Rate of Return to Expect

If I had the answer to that, I would be a billionaire in the making. No one knows exactly, but there are a few ways to get a reasonable answer. At the end of the day, that’s all we should expect. A reasonable answer allows for good retirement planning because all we can do as savers is plan conservatively and let everything else fall into place.

Of course, annual return assumptions have a tremendous impact on how much we need to save. We could easily assume 50% annual returns and then save only $5,000 for retirement in our 20s since such a ridiculously high return would leave a 25 year old with more than $55 billion at age 65. But that’s not realistic, and a high assumption just leads to disappointment and the inability to retire at an old age.

The Theoretical and the Practical

History suggests investors get something like 6% annual returns (inflation-adjusted) from the stock market as a whole. That’s historical, of course, which just implies that based on what happened in the past, we can project that return into the future and hope for the best. (Here’s a great calculator for historical S&P 500 returns.)

Hoping for the best is exactly what we’d be doing with a 6% annual return projection. In practice, you should plan for returns lower than historical norms.

If I were a betting man, I’d wager that 20-somethings will achieve a lower return on their stock investments than their parents and grandparents enjoyed. Here’s where the theoretical and historical plays in: when interest rates are low on alternative investments like bonds, the stock market usually rewards investors with very low returns, too. Right now, interest rates are very low.

Low interest rates tend to lead to low stock market returns. People who run companies are paid far more for growth than stagnation. When rates are low, managers have an incentive to invest the business’s capital in projects that net a very low return. You can read more about that in an article from The Economist.

Also, an investment is as only good as its alternative. When bonds promise low 3% returns for 30 years, a 5% return from stocks doesn’t look so bad any more.

Settling for Lower Returns

Smart saving requires a conservative approach. If you plan very conservatively, the worst that happens it that you have too much money at retirement. Most people would agree that’s better than having too little money at retirement.

Therefore, plan for something realistic like 4% annual real returns from the stock market. Here’s why I think a 4% return is a reasonable assumption:

  • Dividends give you 2% off the bat – If you invested in a S&P 500 index fund today, you’re going to get about 2% of your investment back in the form of dividends each year. These dividends help boost returns without any increase in stock prices.
  • Growth of 2% isn’t ridiculously optimistic – After adjusting for the 2% dividend yield, investors would only need stock values to increase by 2% more than inflation to get a total long-run return of 4% on their money. While you shouldn’t expect a consistent 2% return per year in excess of inflation, it makes for a relatively modest assumption over very long periods of time.

An assumption for 4% real returns (returns minus inflation) is a good starting point for figuring out just how much you need to save. While it isn’t what anyone wants to hear – 6-7% annual returns would be much better – it’s a conservative return that would still leave every dollar invested in your 20s to grow to $5 or more of inflation-adjusted wealth by retirement age. That’s still not a bad outcome by any measure.

The good news is that I can be wrong and people who start saving earlier might get higher returns over the next 20 years. Maybe I’ll be much too pessimistic and you’ll be rolling in money Scrooge McDuck-style in your 40s, at which point you’ll be happy you planned conservatively. Maybe I’ll be wrong and returns will be even lower than 4%, in which case those who had a headstart will be happy they saved so aggressively.

The key is to start early and contribute often. No one knows what the future will bring, but I can tell you with certainty that those who make a reasonable projection and save for their goals will be in a much, much better position than people who count on 20% annual returns to make their retirement dreams come true.