The power of compounding is an important concept that investors need to understand. Investing regularly and starting earlier in life (ie, age 25) can result in hundreds of thousands more dollars in your investment account than if you started 10 years later.

While some personal finance experts suggest that a stock investor can expect a 12% annual return, when you include the effect of volatility and inflation, 7% is a more historically accurate estimate. for an aggressive investor (a person who mainly invests in stocks), and 5% is more suitable for someone who invests in a balanced portfolio of stocks and bonds.

The chart below illustrates how much difference account balances can make using different return assumptions, if you save $100 a month in a Roth IRA.

While it’s true that you can achieve a balance of around $1 million if you save $100 per month for 40 years assuming a 12% return, that’s just not possible when you factor in market volatility and inflation. In fact, if we assume a 7% return, which although may be a touch optimistic, it would require saving $400 a month, or four times as much, to generate the same $1 million.

In other words, not only is 12% an incredibly unrealistic assumption using historical data, but it’s also actually dangerous because it could result in less savings for retirement.

So, where does the 12% come from?
Investing is a fundamentally uncertain exercise. No one knows what the markets will do in the future, and so a common starting place is to look at the historical performance of the US market.

The US has had one of the best financial markets in the world over the last century, and while this may paint an unrealistic picture about future market performance, it provides some useful context about expectations. One of the most commonly used historical data is the Stocks, Bonds, Bills, and Inflation (SBBI®) series.

The SBBI data spans 98 calendar years, from 1926 to 2023. If we take the simple average of historical returns over this period, you get 12.2%. That’s the 12% everyone keeps talking about!

The problem is, even if you invested in the same stock market index over that period, you actually got 10.3% (not 12.2%), because of volatility effects. Even the 10% estimate does not include inflation, which averages about 3% a year, further reducing historical returns of around 7%.

Tack on things like fees and taxes, and even 7% is probably a pretty high long-term return assumption for a portfolio, especially based on current market forecasts. If you invest in a balanced portfolio, your return after considering volatility and inflation will be closer to 5%. I will delve deeper next time.

Innovation is not your friend
The simple average, or arithmetic average, is calculated by adding a number of values and dividing by the number of observations. Therefore, the 12.2% historical long-term average return is estimated by summing all historical returns (which equals 1,191.81%) and dividing by the number of observations (98).

The problem with this method is that it doesn’t accurately reflect what happens to wealth if you experience a negative return. Simply put, negative returns hurt long-term performance more than positive returns. Here’s an example: Let’s say you have an initial portfolio worth $100 and it achieved a return of +100% in the first year and -50% in the second year. The simple average return would be +25% (+100% + -50% = +50% / 2 = +25%), which suggests that you will have a final balance of around $150 at the end of the two-year period. It’s very nice, isn’t it? However, in reality your final balance is the original $100, and your realized return is 0%.

How can that be? Well, if you had $100 and the portfolio return was +100%, you now have $200. If the return is -50% you lose half of the balance and you get back the original investment of $100. That’s because negative returns hurt more than positive returns when it comes to building wealth, and why you can’t use the simple average as the expectation for long-term performance.

A better metric is the so-called compound return, or the geometric return, which clearly includes the effect of volatility on wealth growth over time. I won’t get into the weeds here, but here’s a reference if you’re interested in learning more about the calculations. However, what is important is that using geometric returns, the growth rate of an investor’s portfolio would not have been 12% historically, it would have been closer to 10%.

Are there 30-year periods where the geometric return is higher than 12%? Alas! The highest average 30-year geometric return is 13.7%, so it’s possible. At the same time, however, the lowest average 30-year geometric return is 8.5%, so it is also lower.

Inflation is not your friend either
The second important consideration that the 12% long-term return estimate ignores is inflation. Inflation is simply a measure of how a set of goods or services has changed over a certain period of time. The most common estimates of inflation in the US are based on the consumer price index (CPI), which is calculated by the Bureau of Labor Statistics.

The long term inflation rate from 1926 to 2023 is about 3%. This means that the price of goods and services increased by an average of 3% per year during that 98-year period. When thinking about long-term wealth growth, we need to back out inflation, because we want to buy things in dollars now. That means a 10% geometric return is more than a 7% return when we account for inflation.

Using returns before inflation, called nominal returns, effectively assumes that everything will cost the same in the future, which is incredibly at odds with historical evidence and future estimates of inflation rates.

Other considerations
The initial 12% return is reduced to 7% when considering the implications of volatility and inflation, but there are other considerations that could cause it to go even lower. This includes fees, taxes and asset allocation.

First, let’s talk about payment. The return of the index does not account for any kind of historical fees, but investing is never free, especially if we go back in time. The Vanguard S&P 500 investor index had an expense ratio of 0.43% back in 1976. The cost of investing is even higher if we go back further in time. While these costs have dropped significantly, almost to zero, they are certainly not historically zero, which reduces the returns realized by investors.

Second, we cannot forget about taxes. Taxes can reduce compound returns for individuals, especially those who invest in a taxable account. This is something known as tax drag, and can be especially important for investments with higher levels of income or turnover.

Third, asset allocation has an impact on returns. Few retirees should invest entirely in equities. A decent target for how much of your portfolio you should have in equities is 110 minus your age. So, at age 65, a 55% equity allocation is a reasonable place to start. If you consider a balanced portfolio of 50% stocks and 50% bonds, the 7% geometric after inflation return drops to 5%.

Now what?
While 7% is a more accurate reflection of long-term investment returns in equities, and 5% for a balanced portfolio, it is important to note that these historical returns do not necessarily align with predictions. As previously noted, the US has one of the best financial markets in history, and I worry that future returns will be more similar to our international peers. For example, PGIM Quantitative Solutions Q4 2023 Capital Market Assumptions for future inflation-adjusted returns on stocks is closer to 5%, which is lower than the historical long-term average.

The use of lower expected returns may result in higher required savings rates of accumulation or lower levels of retirement spending, but it is important that the assumptions of any financial plan be as reasonable as possible. , and to repeat, a 12% return assumption in stocks is not just. It’s not fair, it’s dangerous.

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This article was written and presents the views of our contributing advisor, not the Kiplinger editorial staff. You can check advisor records using DECLARED by SEC or with FINRA .