What’s a Good Estimated Market Return (Growth Rate) to Use?

I decided to write this post after seeing how many people across the personal finance community and social media are using an estimated market return of 10% in their illustrations and forecasts. If you’re one of those people; I promise that I’m not trying to pass judgment. However, I do want to make sure that you’re considering all the appropriate factors before selecting which market growth rate to use.  

I’ve always been a bit risk-adverse, so the thought of using a 10% or higher rate stresses me out. I tend to use much more conservative market return rates. Because of this, I’ve picked apart historical return statistics and considered all of the factors below when deciding what estimated market return rate to use for our own financial forecasts.

Let’s talk through historical rates and what a realistic growth rate might be to use when projecting investment growth.

If you are using market growth rates for purely motivational purposes, by all means, keep using whatever works for you. However, if you’re attempting to educate others or using your forecasts to make financial or life decisions; it’s important to make sure the analysis is based on realistic growth rates.

This post contains my personal opinions and philosophies based on my own research. I would encourage you to do your own research before making major financial decisions. Nothing within this blog post is intended to be investment advice.

Understanding historical growth rates

Since we can’t predict the future, the best we can do is estimate future market returns using historical returns and our knowledge about the current economic environment.

However, there are dozens of ways to calculate and present historical market growth rates. It’s important to understand the context of a statistic before you rely on it.

Average market return vs. Compound Annual Growth Rate (“CAGR”)

Average annual returns represent the mathematical average of market returns experienced each year over a defined period. This is the most common way I’ve seen historical market returns presented. However, this method tends to smooth out market returns, which can skew the percentage compared to other measures.

CAGR, on the other hand, calculates the annualized return using the starting and ending points and then dividing by number of years in the period. I believe CAGR to be a superior and more representative measure to for presenting historical rates of returns. Rolling averages will generally present similar results.

Let’s look at an example. In this case, we buy a stock for $100 that does not pay dividends. After 1 year, the stock falls by 15%, but then increases over the next two years by 20% and 10%, respectively.

At the end of year 2, the average rate of return is 2.5% (-15% + 20% /2). However, this rate of return is misleading, because at a price of $102/share, we are not actually 5% (2 years x 2.5%) better off. The CAGR, which represents a more accurate calculation of return, is only 1%. After three years, the average annual rate of return is 5.0% and CAGR is 4.07%.

To further demonstrate these differences, let’s look at some actual historical returns over longer periods below, each ending on 12/31/2020.

The largest differences between these two measures will be seen in times of significant market volatility or over shorter time frames. In general, CAGR has historically been around 1 to 2 percentage points lower than the annual average rates over longer periods.

All of the returns above do not include adjustments for inflation, which we’ll discuss next.

Inflation

If you’re an American millennial, you probably haven’t worried too much about inflation, until recently that is. That’s because the US has experienced relatively low levels of inflation over the past 20 years, with an average annual rate of 2.12% between 2000 and 2020.

What is inflation?

Inflation is the rise in price of a bundle of goods or services over a period of time. Although some goods may decrease in price over time, such as technology, the cost of most goods and services will increase year after year. That’s why the new Ford F-150 pickup truck you could get for less than $4,000 in 1979 starts at around $29,000 today.

The rate of inflation depends on the current state of the economy as well as the government policies designed to control it. Higher inflation rates were normal during the 20^th century, with average inflation rates of over 7% during the 1970’s and 5.6% in the 1980’s. Government policies (and probably a bit of luck) have helped to keep rates lower in recent years. However, policies can only do so much without causing problems in other areas of the economy.

How does this factor into my market return?

Because inflation will impact how much you can buy with your invested funds in the future.  

The quick and dirty method of determining your FIRE Number uses expected annual expenses in today’s dollars. Inflation is not automatically factored into the calculation.

In reality, the cost of each of the line items in your budget will increase every year. It’s safe to assume that long term inflation will be at least 2% for most goods and services (the Fed’s target inflation rate). However, some buckets have experienced even higher long-term inflation rates, such as medical costs at over 5%.

Although your investment portfolio will continue to grow, the amount you’ll need to fund your retirement will also increase. Unless you are also increasing your expenses each year for inflation, you should probably reduce your estimated market returns a bit to account for the decrease in purchasing power.

During your working years inflation shouldn’t hurt too much, since you’ll (hopefully) receive pay increases that at least keep up with inflation. However, once you retire and begin relying on your investment portfolio, the annual returns may align with the growth rates you forecasted, but the percentage of your annual expenses those returns will cover will continue to shrink.

Let’s look at the historical impact of inflation on the CAGR rates from above (periods ending December 2020).

As you see, that 30-year average annual return of 11.17% falls to only 7.69% after factoring in true annualized returns and in inflation. In fact, none of these rates are even close to 10%. And we’re not even done whittling the rate down…

Investment Fees

The last expense that’s typically excluded from published historical market returns, but will reduce your actual returns, is investment fees. These are the fees charged by your broker or financial adviser (if you have one).

We handle our own investments and primarily invest in low-cost index-based funds (mutual funds and ETFs), so our fees are pretty low (less than 0.1%). However, if you do employ an advisor or invest in actively managed mutual funds, then you might have annual fees of up to 0.5% – 2% for those accounts.

High fees will seriously erode your future investment potential, and active management has been proven time and time again to be no better than indexing after accounting for the higher fees. I highly recommend understanding the fees you’re paying and making a change if they are on the higher end.

There are so many free educational resources and thousands of low-cost mutual fund and ETF options available now. It just doesn’t make sense to give that money away. Okay, rant over).

Whatever your investment fees are, make sure you’re factoring them in when determining what expected market growth rate to utilize in your projections.

Don’t double count dividends

Historical rates of return almost always include both capital appreciation and any dividends or interest paid during the period. As such, an annual return of 4.5% might include a dividend of 1.5% and market appreciation of 3%.

While it’s great to reinvest dividends during the wealth accumulation years, you’ll likely want to collect and spend this passive income during retirement to offset your expenses.

If you’re using total returns to determine your estimated market growth rate, make sure that you are not also adding in any dividend or interest income on top of that to avoid double counting. I’ve made this mistake before.

Other factors to consider when picking an estimated market rate of return

Asset allocation

Your future returns will be determined in large part by the allocation of your investment portfolio. Stocks, bonds, real estate, and cash are the most popular investment classes, but each have vastly differently historical returns and future potential.

The historical annual returns discussed in the sections above were all based on returns of 100% large-cap equities (S&P 500).

Stocks and other equity investments offer some of the highest returns over the long term because they are more volatile and carry a higher risk. Cash is the most stable investment class but offers the lowest returns. Bonds, commodities, and real estate typically fall somewhere in the middle over the long term.

Hopefully, you are holding an investment portfolio that is appropriately diversified and contains at least a small portion of these other asset classes. If so, you shouldn’t base your market growth rate solely on the historical stock market returns, since those other asset classes will drag down your portfolio’s average rate of return over time. They’ll also protect you from market swings though, which is important in retirement.

The best method, in my opinion, is to develop a range of estimates by asset class after considering the other factors in this post, and then calculating a weighted average estimated market rate (or range of rates) to apply to your portfolio.

Time in market

As mentioned above, the stock market can be extremely volatile.

For shorter time periods, it’s exceedingly difficult to predict market returns. Because of this, it’s better to use a more conservative estimated market return, basing your returns on historical returns over a similar timeframe. If you’re predicting investment growth over a longer timeframe, then long-term historical returns will be a good indicator of future performance. Though in either case, future returns could be drastically different from the past.  

Here’s a look at the best and worst rolling average market returns for the S&P 500 between 1973 and 2016: 

What estimated market return rate do we use?

In the detailed projections I’ve created for our financial planning purposes, we currently use a market growth rate around 6%. This rate includes dividends and interest but does not adjust for inflation. That’s because my model builds inflation into future expenses, increasing most costs by 2% each year, with medical expenses by 5%.

This would equate to an inflation adjusted return of around 4%.

I admit that this is pretty conservative compared to the 30 and 50-yr historical inflation-adjusted CAGRs above. However, I’m okay with that, since this model is designed to stress-test our FIRE plans and whether we’ll run out of money.

Additionally, we aim to hold around 15-20% of our investments in bonds and maintain a robust emergency fund, which lowers our overall risk and returns as compared to the S&P 500. As we grow older, we may want to increase this percentage even more to further reduce risk. On a weighted average basis, this rate appears much less conservative.

Takeaway

There are a lot of factors to consider when picking a market return rate to use for forecasting purposes. Hopefully, this post has showed you all the things to consider when determining what market return makes sense for you.

After all, you wouldn’t want to get your hopes up or make bad financial decisions by selecting an unrealistic market growth rate.

My personal opinion is that rates of 10% are too aggressive for most situations. I think a better rate would fall somewhere between 5% and 7% for an all-stock portfolio, if inflation is relevant to the analysis. The rate would be even lower for a more diversified portfolio, which how much lower depending on the portfolio allocation.

Again, this is just my opinion. You’ll have to use a market return that feels right for your situation (after doing your research, that is).

What market return rate do you use in your financial planning?