What investment return should you plan for?

Or: Why every retirement calculator is wrong

I bet you’ve heard of the Latte Factor. Or as David Bach would like you to call it, The Latte Factor®. In his trademark anecdote, Bach talks to a woman about the benefits of giving up her $5-a-day coffee, investing the cash instead, and ending up with more than a million extra dollars by the time she retires.

How does he come up with such high figures? By assuming that stocks will give her a 10% “average” rate of return. Take a little money, compound it at 10%, and voila, it becomes a whole lot of money.

Oprah does it too. Back in 2007, she had a several viewers on the show with lots of debt and little-to-no retirement savings. A team of personal finance experts worked with them to devise a financial plan that would save their retirements. A 23-year old with no retirement savings left the exercise with the promise that at retirement, she would have $920,000! The actual monthly savings—from cutting her credit card interest rate and getting a new roommate—only added a few hundred dollars a month. The real secret, of course, was 10% compound interest over 40 years.

The myth of the 10% return

If only that return were guaranteed. It’s true that the historical average return for stocks since the late 1800s has hovered around 10%. But that figure starts to look pretty shaky when you think about how it was derived.

First—and let’s get this straight—120 years is not a long time for a statistician. To get mathematically sound data for an analysis of stock performance, you need time periods that don’t overlap. Since you might assume that each of us has about 40 working years, that makes only 8 non-overlapping investment cycles to look at. Do you see many scientific polls conducted on 8 people? Would you predict the average temperature in a year based on the last 8 days? Didn’t think so.

But more important, it’s not clear that we should be averaging stock returns at all. The last century saw the rise of the America from a secondary player to the only global superpower. Do we really think that’s going to happen twice?

And the order of returns matters more

And even if there does exist a statistically valid average rate of return, in practice, that would mean almost nil to a real investor. It matters much more to you and I, who invest a little bit each month, what order the returns come in. To prove this point, I ran a little experiment, using the monthly total returns of the S&P 500 from Standard & Poor’s website.

An investor who started with $0 saved and invested $500 per month between February 1988 (when the data started) until the end of last year end up with a shade under $300,000 in his retirement portfolio. But what if we reversed those returns? The “average” would be the same, but the twin stock market crashes of 2002 and 2008 would occur at the beginning of the investor’s lifetime instead of at the end.

The result? That same investor, putting away $500 per month, would have ended up with about $615,000–that is, twice as much as the other investor, but with the same average return.

So what can you plan for?

The problem, of course, is that you’ve got to plan for something. Pretty much every retirement calculator out there asks you to input a predicted rate of return. And choosing an optimistic 10% will make your retirement situation look much rosier that it might be in reality. Heck, CNNMoney’s retirement calculator says that I—with more than two decades of work ahead of me—don’t have to stick another penny into retirement savings to replace 80% of my income! Are we beginning to see a problem here?

In the absence of good information, it’s always best to err on the side of safety. How low you go depends on your comfort level. Personally, I’m not counting on a rate of return above 6%. The current going rate for a guaranteed return from Treasury bonds is 3.7% for the next 10 years. A couple percentage points of return for taking on the extra risk of stocks seems reasonable.

Relying on a low rate of return will mean that I save more money and earlier. If the actual rate of return ends up being higher over the next decade, I can easily go back to my portfolio and scale down the amount I’m saving or, better yet, re-allocate my portfolio more conservatively to insulate myself from a possible calamity like 2002 or 2008 down the road. When it comes to investing, it’s much easier to slow down than to play catch up.

Tools:
ESPlanner Basic is my favorite retirement calculator. It lets you analyze your retirement situation two ways: The same way a financial planner does, and the way an economist would. It’s hard to explain in a couple sentences, but check out the site to learn more.

If you’re looking for more of a back-of-the-envelope calculation, check out T. Rowe Price’s retirement calculator. Note that this calculator does assume a 10% return on stocks, unlike ESPlanner, which lets you adjust the assumption.

Tagged as: Investing, retirement