Tuesday, August 23, 2011

The Myth of the Seven Percent Solution.


I was reading an interesting blog post about Unrealistic Returns In Personal Finance Writing in which the author quotes personal finance gurus like Dave Ramsey as stating the average return of stocks is 12-15%. The author's point is that 12% and above is absolutely absurd, and it's outright irresponsible for a personal finance expert to being giving such misleading and incorrect information to unsuspecting people.

Posts like that make for good comment fodder, being full of rebellious righteousness, but the truth is that it all depends on your definition of average, and what exactly you're including in that performance figure and what you mean by "stocks".

Consider that the stock market as a whole has returned an average of 12% per year before inflation from 1900-2010. This isn't too far off the standard advice I've always heard of 10%. It turns out that 10% isn't too far off 12% adjusted for average inflation of 3%.

For the record, that blogger was of the opinion that 7% is a more reasonable expected return going forward for stocks, since the recent market upheavals of 2008 and 2011. He even states that stocks have returned an average of 3% over the past decade.

Interestingly, 7% is right about where Warren Buffet sees stocks - after inflation.

But that's still about 3% lower than the 10% figure after inflation right? Not so much. You see, the other factor at play is dividends. The long term average yield of the S&P 500 is often stated as being 2-3%. Warren Buffet's figure does not include dividends. If we add this number to Warren Buffet's after-inflation-figure we get right back to the 9-10% range.

The author of the afore mentioned post made no mention of dividends, so I can only assume he was not taking them into consideration. Neither did he state whether he was considering inflation in those returns.

In short, I believe his 7% solution is really just the 10% version without dividends.

So is Dave Ramsey quoting 12-15% really irresponsible? Every time I've heard Ramsey say such things he is specifically referencing mutual funds and quoting the rate of return before inflation and taxes. I suspect the blogger above is comparing 12-15% to S&P 500 index funds, which would be a stretch. But it is quite possible to find mutual funds that provide the kind of return Ramsey suggests - especially small cap funds.

Let this be a reminder that the average rate of return can vary, especially when the meaning varies. :)

And one last thing to consider - the recent upheaval in the markets (i.e. wild, 600 point swings) makes for inefficiencies, which also makes opportunity. An actively managed mutual fund has a manager that can capitalize on these opportunities and add some points to the fund's return. And index fund cannot. If anything, that meager 3% return over the past decade should make it all the easier for a managed fund to beat the average, so it could be argued that we should expect higher returns than 7% over the next 10-15 years for some mutual funds.

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