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Why You Need to Earn 10%

Odds are that like me, you've heard plenty about asset allocation. You've read that as we get older, it can make sense to move some of our money out of stocks and into bonds. Many advisors would even park a sizable chunk of your money into bonds right now, even if you're still 10 or 20 years away from retirement.

I know that for long-term money, stocks almost always outperform bonds. According to research from business professor Jeremy Siegel, stocks have outperformed bonds 74% of the time over all five-year periods between 1871 and 2001. Over all 10-year periods in the same span, that figure rises to 82%. Meanwhile, stocks outperform bonds 95% of the time over all 20-year periods, and 99% of the time over all 30-year periods!

Still, you might rationalize to yourself that keeping, say, 25% of your moola in bonds can't be that bad. Well, it might be. Financial advisor Kim Snider offered an eye-opening perspective recently in her blog. In discussing red flags that you might encounter from financial advisors, she included this: "Constructing a portfolio for you with an expected annual return of less than 10%."

Her reasoning is reasonable. Let's assume an average annual rate of return of 10% for stocks, which is the historic rate over many decades. Let's also assume an average return of 5% for bonds. If you have a portfolio split 50/50 between bonds and stocks, you could expect to earn about 7.5%. With 25% in bonds and 75% in stocks, your expected return is 8.75%.

Here's the rub
What's the problem? Well, as Snider points out, if you want to build wealth for retirement, and you need to incorporate taxes and inflation into your math, then you really need an average rate of return close to 10% over the long haul. She uses a target annual withdrawal rate in retirement of 4%, as has Robert Brokamp in our Rule Your Retirement newsletter.

In Snider's own words, her formula is:

your withdrawal rate plus inflation divided by one minus your marginal tax rate

Using a 3.5% inflation rate, and a 25% tax bracket, this comes out to exactly 10%. She concludes that any advisor who has you lined up to earn less than 10%, on average, over the long haul, isn't serving you well and should probably be cut loose.

How to get that 10%
Your next question might be, "How should I get that 10% return?" Fair enough. There are a handful of ways you might do so. For starters, you could simply go with a basic broad-market index fund, such as one based on the S&P 500. That will give you the market's returns, which have averaged 10% in the past.

The only problem with that is that it's not a guaranteed 10%. The market may have averaged 10% over the past many decades, but during your 20 or 30 or 40 years of investing, the market might average 8% or 12% or some other return.

You might aim higher than 10% by judiciously investing in a few individual stocks that have the potential to top that level over long periods. Boeing (NYSE: BA  ) , for example, has averaged 12% over the past 20 years, while McDonald's (NYSE: MCD  ) and General Mills (NYSE: GIS  ) have averaged 14%.

You might also opt for some top-notch mutual funds. The Meridian Value Fund (MVALX), for example, has averaged nearly a 14% return over the past decade. Recent top holdings included Nokia (NYSE: NOK  ) , Avon Products (NYSE: AVP  ) , Anheuser-Busch (NYSE: BUD  ) , and Baxter International (NYSE: BAX  ) .

Keep learning
A comfortable retirement is most likely within your reach -- if you start planning and investing effectively today. We'd love to help you with that. Our Rule Your Retirement newsletter service distills what you really need to know into a manageable volume each month. A free trial will give you full access to all past issues. The newsletter regularly offers recommendations of promising stocks and mutual funds, too.

These articles may also be of interest:

Longtime Fool contributor Selena Maranjian owns shares of McDonald's. Anheuser-Busch is a Motley Fool Inside Value recommendation. The Motley Fool is Fools writing for Fools.


Read/Post Comments (1) | Recommend This Article (17)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 14, 2008, at 2:42 PM, lrecap wrote:

    As usual, using hind sight is great, but usually not a good basis for looking/committing ahead. It does not seem prudent to put ALL of your investments into stocks only, unless maybe you have more than 30 years to go to retirement, and can readjust as you approach retirement. Yes, all stock/equity has the highest "potential" of the biggest return (based again on history), but it is also the most volatile. I have read from a number of sources that are the deemed the best that the return forecasted for the next 10(s) of years may be most likely lower than the "historical" stock average return (along the lines of returning ot the mean after the last 6 or so years). So is it really the best advice to investors to have zero bonds (which brings the return average down - at least I feel that is what the article is implying)?

    lre

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Selena Maranjian
TMFSelena

Selena Maranjian has been writing for the Fool since 1996 and covers basic investing and personal finance topics. She also prepares the Fool's syndicated newspaper column and has written or co-written a number of Fool books. For more financial and non-financial fare (as well as silly things), follow her on Twitter...

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