Whenever we talk about calculating our retirement wealth gap, a common question comes up. This is the question of investment assumptions. What should we assume for our ROI when making these calculations? This can be a complicated issue because one of the ways to find the answer is to look at historic data across market indices.
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Before we begin, I must mention that this information is not investment advice, but in today’s entry, I’m going to try to help you understand the process of assuming an ROI for wealth gap calculations. As they say… past performance doesn’t indicate future results and any assertion to the contrary is a federal offense.
Several years ago, I read a book by Dave Ramsey that I really enjoyed. However, he made a claim in the book that has haunted him ever since. In fact, he has received so much ridicule over the statement that he actually created a page that was dedicated solely to this claim, on his website. You see, Dave made the claim that you could get a 12.25% return on your investment portfolio. How did he come up with this figure? Well, he took the average annual return of the S&P 500 from 1923 through 2016.
However, timeframes matter, and when assuming an ROI for wealth gap calculations, so does accuracy. So, how does time factor into this assumption? Well, let’s shift the dates just a bit. If we look at the average annual return of the S&P 500 from 1923 through 2019, the return drops from 12.25% to 10.48%. Similarly, if we went from 1999 to 2019, the average rate of return falls all the way down to 6.68%. Folks, we can look to the past and we can learn from it. But, we have to be careful not to get sucked in by illusionary numbers. I mean, just think of the damage that would be done to our plans if we assumed a 12.25% return and, instead, yielded just 6.68%. It would be devastating. So, again, timeframes matter.
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By now, it’s clear that the timeframe matters when assuming an ROI for our wealth gap calculations. But, we also need to focus on the dividend rates. By removing the dividend rate from the S&P 500, the average annual return from 1923 through 2019 drops from 10.48% to 6.26%. That’s a difference of 4.22%, folks! But let’s keep going. Using the 1999-2019 timeframe, the return drops from 6.68% to 4.68%. So, it becomes immediately clear that removing the dividend from a timeframe, also affects things.
On March 28, 2013, the S&P ended just above 1569. This was a record close. Why is this so important? Well, this record closing, surpassed a milestone that had been set in 2007. That means that from 2007 until March 28, 2013, the S&P had operated in negative territory. What if the next seven years repeated that? All of this is to say that, although I agree that the stock market as a whole, returns in positive territory over a ten-year period, it can’t be relied on. There are always going to be anomalies that come and go, affecting the average rate of return.
Here’s where things get really interesting. Stocks have actually beaten the inflationary rate over the long-term. However, they tend to struggle during periods of high inflation. This should be especially concerning, given this year’s signing of the CARES Act. I’m not saying anyone should panic, but we should definitely pay attention to what is taking place around us. Staying informed of where we rest in the economic cycle is the best way to remain proactive and in control of your own financial situation.
RELATED READING: The CARES Act, Inflation, and Your Wealth Gap – How Concerning?
Adding some perspective to this, if we look at the markets from 1916 through 1918, we would see that they actually performed in positive territory, boasting an average ROI of 1.32%. However, if we remove the dividends, the market lost 5.59%. And we see this time and again throughout inflationary trends. From 1946 to 1947, the market performed at -5%. When taking the dividends away, it was even worse, coming in at -9%. Once again, from 1973 to 1981, the S&P 500 showed a 5.08% return that fell to 0.42% when the dividends were removed.
So, what if we’re currently sitting on the cusp of another ten-year inflationary period? This is a big deal, folks. If you’re making your assumptions based on the 12.25% return that Mr. Ramsey said you could expect, and we are heading into such an inflationary cycle, then chances are good that your calculations won’t work out in your favor. So, what do we do?
When looking back at these indices, we have seen several different cycle types. The first one is known as a secular cycle. It is a ten to thirty-year period. Next is the business cycle, which is the one I was using in my examples. It looks at a one to ten-year period. Finally, there is the tactical cycle, which examines one to twelve-month periods of time. When we look at cycle-type investing, we can find areas or sectors that, theoretically, provide us with a better return.
Now, I want to point out that nothing is guaranteed. But, there are certain positions that perform well during the growth side of the cycle and some that do better on the recovery side. For example, during a recessionary cycle, we often see industrial, communications, and real estate positions fall. However, oftentimes, consumer staples, healthcare, and utilities begin to rise. Once again, this isn’t always the case. But this is why we always talk about ultra-diversification in our investments.
You might be thinking that you can just assume a 6 or 7% return and be done with it. The thing is, it isn’t that simple. You have to account for your glide path. What’s the glide path? Well, when a plane begins to make its descent, it has to start decreasing altitude miles ahead of its destination. If they tried to simply go from cruising altitude to landing, the results would be catastrophic. The same can be true of our investment portfolios. Glide paths in the financial realm refer to asset allocation mixes and target-date funds. Basically, the older you get, the more conservative the investments become.
You see, even the most experienced investors will invest in positions that are opposite one another. As a result, we don’t often see a consistent 6-7% return, net inflation. So, when assuming an ROI for wealth gap calculations, we have to be mindful of our glide paths, as well. As you’re making your calculations, you also need to gradually minimize risk. Many of you are probably thinking, “Justin, I don’t know how to do all of this stuff.” Well, that’s why you hire a professional. We do this every single day.
Friends, I don’t tell you these things to discourage you. Quite the opposite, actually. I want you to be aware of the difficulties and complexities that are involved in planning for your financial future. Speak with your financial planner. If you don’t have one, reach out to us. Life is hard. Life can be frustrating. But with a little knowledge and a great financial planner, assuming an ROI for wealth gap calculations can be, at least, financially simple.
If you have questions about this or other areas of your financial life, reach out to us. The Financially Simple team has helped thousands, just like you!