Last week, I wrote about how $350/month can become $1 million in 30 years, thanks to the power of compound interest. Many of you commented that this was a fantasy, because the calculation assumed a 12% return, which was unrealistic. (I was THRILLED to see so much discussion, to be honest, because it helps me learn.) So this week, I did some more research to see what level of return I can realistically expect over time.
As background – this is the data David Bach shares in his book Smart Women Finish Rich. I understand the flaws (it’s only over a 17 year period, doesn’t include 2008 crisis, etc.). He’s updating his book this year, so I’ll be curious to see if he changes his assumptions.
According to my unscientific Google search, the consensus seems to be that we can expect nominal returns of 10% per year in the long term (average annualized total return of the S&P 500 over the past 90 years is 9.8%), but that excludes inflation of 2-3% per year (which is where the 7% estimate comes from). That’s assuming you buy and hold for the long term, thus avoiding commissions and taxes, as well as the effects of poorly timed trades. If you don’t practice “buy and hold” investing, then your returns are likely to be closer to 6-7%, which is another reason what many financial advisors quote the 7% number (including Warren Buffet).
Using this information, I went back to my favorite interest calculator to see what that $350/month would get me. Assuming a 10% interest rate, I’d have $800,000 in 30 years (yes, I know, that’s not adjusted for inflation), or only $429,000 assuming a 7% interest rate. A few percentage points can make a big difference. I’d have to invest $450/month to have $1 million in nominal terms (10% interest rate), or a whopping $850/month to have $1 million in real terms (7%). Yikes!
The real benefit of this debate is that it’s helped to crystallize in my mind some of the fundamentals of investing (which I’m sure you all know, but I’ll write here for those who are too embarrassed to say otherwise).
1) Invest for the long term.
While the average return is 9.8%, there is huge variability in annual returns (see the graph below – the y-axis it the % of years in the 78-year period that saw those returns). By constantly adjusting your portfolio based on short-term market trends, most people lose money (unless you are a professional, or just really good at this).
2) Reduce costs through passive investing.
Passive investing seems to be gaining in popularity over actively managing investments (managing them yourself or buying into an “actively managed fund”), and, even better, has been shown to earn better returns over time. According to one article I read, 83-95% of active money managers fail to beat their benchmark’s return in any given year. While passive funds track the market, they also have dramatically lower costs, which eat into your return. The S&P 500 index funds seem to be most popular to buy and hold for that 10% return; in the coming weeks, I’ll be digging into this more (my boyfriend is a big fan of emerging market funds – I’m not so sure yet).
So that’s it. It’s a lot harder to become a millionaire than David Bach promised, but I’m grateful for the debate and glad I’m paying attention now. I’ve dramatically adjusted what I do with my money to try and squirrel away as much as possible for the future. I still need to take a closer look at my retirement accounts – and whether I should invest in one of those “target retirement plans” vs. balancing my portfolio, as well as where I should be keeping my money (US, UK, offshore). It feels good to be on the right path, though!
Further reading
- What is the average stock market return? (NerdWallet)
- Active vs. passive investing: Step back for better returns (NerdWallet)
- Average stock market return: Where does the 7% come from? (The Simple Dollar)
- Average stock market return will surprise you (Credit Donkey)
- Get ready for dramatically lower stock market returns over the next decade (CNBC)
Austerity Kate 