Realistic Rate of Return – Part 1

# Realistic Rate of Return – Part 1

In producing the many excel spreadsheets that I have that tell me how much I need to save to in order to get x dollars x years down the road, I’m always kind of curious as to what I should put in there for my compound annual return rate. Certainly having a realistic and accurate return rate is vital to any kind of financial planning exercise. Especially seeing as how most of my calculations span 30 or more years of investment performance the return rate can drastically change the final numbers. If I were to set my expected return rate too high I would drastically over inflate my numbers and be poorly disappointed with my actual results.

Just to give an example let say I meet my goal of having \$100,000 by age 30 and lets say at that point I punch in my spreadsheet that from that point I am going to expect a 12% annaulized rate of return. When I hit age 65 that original \$100,000 will have grown to \$5,279,961. Well after seeing that number I decide I’ve got my retirement in the bag and stop saving any more money. Well turns out things didn’t go as well as planned and I only ended up getting 6% annualized returns, well instead of \$5+ million waiting for me I only have \$768,608. That’s a difference of \$4.5 million dollars!! Add in inflation and my original decision to hang up the retirement savings gig at age 30 will turn out to be a horrible decision just because I over estimated my rate of return. See the chart below to see what just a few percentage points can do to my projections.

 Rate of Return \$100,000 @ 65 years old 15% \$13,317,552 12% \$5,279,962 10% \$2,810,244 8% \$1,478,534 6% \$768,609 4% \$394,609

So as you can see this is a pretty big dilema for me. I can do all the planning I want, but if I don’t feed my projections good data I could be in a world of hurt down the road. This is my first multi-part series and I am going to try to explore this topic a little deeper to see if I can come up with a realistic expected rate of return for myself.

What rate of return do you plan/expect from your investments?

Part II – Asset Allocation
Part III – Trying to beat the odds

[tags]Investing, Annualized Return, Financial Planning[/tags]

• One thing you should start doing is stop thinking in terms of nominal rates of return, and start thinking in real (inflation adjusted), after-tax rates of return, net of fees. So I think it is clearly a mistake to assume historical equity rates (also because I think the historical equity rate will not be as high going forward). I personally think that a realistic ROR will be somewhere in the neighborhood of 4-5% annually, for a person whose portfolio is 60/40 equity/debt. Using nominal rates gives a highly distorted picture, because of the effects of inflation.

• My Financial Journey

Thanks for the comment! I was going to bring up inflation in one of the other series of posts as it is a very important component of your performance.

Also I am currently 100/0 equity/debt and will probably stay this way for the next couple decades so long-term my annual returns should be slightly higher than a 60/40 ratio.