What do gamblers and financial planners have in common? Both expect the number seven to bring them wealth and riches. Gamblers want to see sevens in the slot machine, while financial planners bank on 7% returns in the stock market.
Any growth forecast for your retirement portfolio must always assume an average rate of return. Mathematically, the growth of your investments can't be calculated without it. And commonly, experts will rely on 7% as that magic number for stock-heavy portfolios. But where does that 7% come from, and what does it mean for retirement planning?
The origin of the 7% return
Thousands of equities are traded in the U.S. stock market, and each is subject to daily price fluctuations. To aggregate those fluctuations and gauge broader stock market trends, investors often look to indexes. Indexes are baskets of companies that represent certain groups, such as technology companies (Nasdaq composite) or blue-chip companies (Dow Jones Industrial Average).Investors look to the S&P 500 index as one barometer for the American stock market as a whole. The S&P tracks 500 companies that account for 75% of the total value in the U.S. stock market. The S&P is also the origin of the oft-quoted 7% return.
Between 1926 and 2018, the average annual return of the S&P 500 was about 10%. Adjust that 10% for inflation, and that brings you to an average annual, real return of 7% -- our magic number. The market showed similar rates of return in other periods as well. Between 1950 and 2010, the market grew 8% after inflation. From 1965 to 1995, the broader market grew 6.6% per year after inflation. The point is, when you look at two or more decades, the stock market usually averages out to about 7% growth.
As you might guess, things look much different when you look at S&P performance in individual years. In 2008, the S&P tanked by 38.5%. In 2018, it was down 6.2%. Historically, those down years have always been offset by years of growth. In 2013, the index grew by nearly 30% and 2019 is tracking for 26% growth.
When a 7% growth expectation is realistic
Because of that year-to-year volatility, the 7% growth expectation only makes sense when you're following a buy-and-hold strategy in your equity-rich portfolio. Instead of buying and selling investments every few weeks or months, you make your picks and hold on to them for the long-term. You can make adjustments over time, but you stay invested even through market downturns.If you get spooked by a market decline and sell off your investments, you lock in your losses, ensuring you miss the upswing that follows the crash. Even if selling off feels like the right thing to do, it takes you out of the running for that average 7% return over time. It's just not realistic to think you can sidestep the downturns but still capitalize on the growth years.
Another factor is how long your money will be invested. If you are forecasting your portfolio growth for the next five years, a 7% return is pretty optimistic. You could get caught in a downturn, like the recession of 2008. Between 2007 and 2012, for example, the average S&P growth after inflation was just over 2%.
The takeaway? Use 7% as your growth expectation to forecast 20 years or more. Be more conservative when you're forecasting shorter periods.
When it's not realistic
As you near retirement, you will gradually move to a more conservative investment style. Usually, this involves changing your asset allocation to include more stable, income investments and fewer equities. With that stability comes lower growth.An analysis by Vanguard demonstrates how returns are affected by your asset allocation. The following numbers rely on actual stock market and bond market performance dating back to 1926. A portfolio of 70% stocks and 30% bonds grew 9.1% annually on average, or 6.1% adjusted for inflation. A portfolio of 50% equities and 50% bonds produced an average annual return of 8.2%, or 5.2% after inflation. With 20% stocks and 80% bonds, the returns are 6.6% and 3.6% after inflation.
Look at multiple scenarios
When you're projecting how your retirement portfolio will grow over time, it's useful to consider multiple scenarios. A savings calculator makes this easy -- just rerun your numbers using 5%, 6%, and 7% to understand how the rate affects your investment balance over time. Plan your savings contributions in your retirement plan accordingly. That way, you're not pulling the lever and hoping desperately that the market brings you those sevens.
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