The Investment U E-Letter: Issue # 228
Monday, April 7, 2003 'The Big Lie' That's Threatening Your Retirement: What Is Your "Real" Return on Stocks?
By Dr. Steve Sjuggerud, Chairman, Investment U
I hate to be the bearer of bad news. But somebody has to be honest about things here. After all, it's entirely possible that your retirement is at risk… and you might not even be aware of it. So today I'll tell you precisely what is wrong with "The Big Lie" being told by brokers and the financial media… and we'll look at a simple way to avoid potential disaster. On the surface, it seems the financial media and the brokerage industry is afraid to give it to you straight. But the truth is they have good reason to lie to you about what's possible… they want to keep your business… The magazine or broker that promises you a brighter future is the one that keeps your business. They need you to keep buying their products. Me? I don't ask anything from you… this is a free letter to help you become a more knowledgeable investor. If you don't like what I have to say, you can stop reading it. It doesn't cost you or me anything. I'm just telling it like I see it. I don't have a mutual fund to sell you. You don't pay me regardless of what you do with your investments. The Truth About Stock Returns So let me tell it to you straight (remember, you may not like it)… I have no problem with this statement: "Nearly every analyst and stock market historian will agree that stocks investors earned 10% a year annualized over the 20th Century." But I do have a serious problem this… "Therefore, because stocks have returned 10% in the last century, Mr. Investor, they will do so again in the 21st Century." This is the pitch your broker gives you. It's the pitch Money magazine gives you. And CNBC… and… and… the list goes on. I don't know if it is shoddy journalism, or a conspiracy in the financial industry to earn themselves higher commissions. But planning on returns of 10% a year for the 21st Century is an awfully dangerous assumption… one that will completely crush the retirement dreams of all individual investors that are relying on this promise. Let me explain what's so wrong with hoping for 10% a year… The Math Behind The Big Lie Threatening Your Retirement Professional analysts agree that stocks returned about 10% annualized over the 20th Century. And they also agree that, when you account for effects of inflation, the annualized return on stocks was 6.7%. (Said another way, inflation over the 20th Century was just over 3%). The "real" return figure (meaning the "after inflation" figure) is made up of two parts, dividends and capital gains. Dividends over the 20th Century were about 4.6%, and capital gains (after inflation) were about 2.1%. So here's the math to get to a roughly 10% return over the 20th Century: 4.6% Dividends, plus
2.1% Capital gains, plus
3.2% Inflation, equals:
about 10% Now let's consider where we are today… Inflation is at 1.7% (if you take out volatile food and energy prices, like oil prices). And dividends are now about 1.8%. That's 3.5%. Add in 2.1% for the average capital gains from the previous century, and we're looking at 5.6% returns over the 21st Century… right? Well, not so fast… you can't assume that the 2.1% in capital gains from the last century will happen this century. In fact, there's a great reason to believe that it won't happen this century. At the beginning of 1900, stocks were relatively cheap (at a P/E of about 13). At the end of 2000, stocks were at a P/E of about twice what they were at the turn of the century. So while some of the capital gain came from earnings growth over the 20th Century, much of it actually came from stocks moving from cheap to expensive. In other words, part of the growth in stock prices was due to companies growing their earnings. But part of it was the luck of the starting point - stocks were cheap at the beginning. This time around, the starting point is ugly. Stocks are expensive. So while we might be able to count on companies growing their earnings, we can't count on capital gains due to stocks moving from cheap to expensive in this century. If anything, we may see the opposite. What To Expect From Stocks In The 21st Century Since it's all theory here anyway, let's guess that out of the 2% capital gains in the 20th Century, 1% was actual earnings growth and 1% was "growth" in valuations (from cheap to expensive). (Keep in mind that earnings growth wasn't just a measly 1%. Remember that dividends are paid out of earnings. So if dividends were 4.6% a year, and earnings grew by an additional 1% above that, then total earnings growth would have been about 5.6% a year). That gets us to a guess for the 21st Century, based on what we know today: - 1.8% Dividends (current rate), plus
- 1.0% Capital gains (our guess above), plus
- 1.7% Inflation (current rate, excluding the volatile food and energy prices)
For a grand total of… 4.5% a year in the 21st Century. Yeesh. Ugh. Is that really possible? Who knows? But I do strongly believe that the guess of 10% a year that's paraded around the media and the financial industry is extremely optimistic. So what do we do with this? It's Time To Take A Hard Look At Your Retirement Figures Unfortunately, I would urge you to do your best to cut back your estimates on stocks for your retirement. While 5% a year sounds miserable, it sure may be closer to reality than 10% a year in stocks. If your retirement numbers for stocks work with 5%, then anything you earn above that is gravy. However, if you're banking on 10%, you may be in for an awful surprise. If you don't agree with me right now, and you've still got 10% stock returns in your retirement guesstimates, at least compromise with me… Cut back your guess to at least 7.5%. It may hurt. It may mean you may have to work longer, or consider other investments. But it's better to make the contingency plans now than have a rude awakening down the road. Your financial planner, your favorite financial media source, and your own head will try to talk you out of it. If you don't change your assumptions at least a little, you're playing with fire. Good investing, Steve Today's IU Crib Sheet - I'm just trying to tell it to you straight. I know it's an ugly thought to consider. But the quicker you make some changes, the quicker you'll make the proper portfolio adjustments and be back on track to retiring when it's really possible.
- Please don't try to place all your chips on the fantasy of 10% a year. You can hope for "the best." But make sure your affairs are in order so that if "the best" doesn't come to pass, you'll still be just fine.
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