You can't know for sure how much you'll make from your investments over the long term. Without a close estimate, you could fall short of your retirement goals.
There's plenty of historical data on how much various investments have returned on average over the years. For instance, one popular estimate suggests that over the long term, you can expect to make about 10% annually by investing in the broad stock market. Bonds have lower returns, but they still tend to outperform cash.
Yet while you can learn a lot from history, counting on it to repeat is a leap of faith. After all, you'll always see warnings telling you that past performance is no guarantee of future results.
The stakes are high
At first, you might not think that the return assumptions you make are that important. Making 9% instead of 10% might seem good enough to get you to your goals.
But even a single percentage point can make a big difference. As you can see in the tables below, return assumptions make a huge difference over time. If you put aside $1,000 for your retirement every month, here's what you'll make over the long haul:
|
Investing |
9% Return |
10% Return |
11% Return |
|---|---|---|---|
|
5 years |
$75,990 |
$78,082 |
$80,247 |
|
10 years |
$194,966 |
$206,552 |
$218,987 |
|
20 years |
$672,896 |
$765,697 |
$873,573 |
|
30 years |
$1,844,474 |
$2,279,325 |
$2,830,228 |
If you can make just 2% more on your investments, it can tack on almost a million bucks to your retirement nest egg after 30 years.
Conversely, if you're trying to figure out how to get to your goals, different return assumptions will have a big effect on how much you need to save. For instance, here's how much you need to save each month to finish with $1 million:
|
9% Return |
10% Return |
11% Return | |
|---|---|---|---|
|
20 years |
$1,486 |
$1,306 |
$1,145 |
|
30 years |
$542 |
$439 |
$353 |
As you can see, the better your returns, the less you have to save. And the earlier you start saving, the bigger that effect gets.
What the future holds
Unfortunately, there's no consensus about what future stock market returns will look like. Brokerage firms like Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS), and Merrill Lynch (NYSE:MER) issue recommendations about asset allocation on a regular basis, but they tend to be more short term in nature and subject to change. Furthermore, they tend to focus more on relative performance rather than absolute returns.
During the boom of the late 1990s, many forecasters increased their long-term projections from 10% to 11%. In the bear market that followed, some of those forecasts came back down as well. Now, as the market surges again, you're likely to see calls for changing those assumptions once again.
One person who has special insight into this question is Roger Ibbotson, who pioneered the use of historical research in guiding asset allocation decisions. He recently shared his methodology with Foolish retirement expert Robert Brokamp, explaining some of the factors he looks at to determine whether historical returns are likely to continue. (You can see the whole interview in the July issue of the Rule Your Retirement newsletter.)
The key to a successful plan is including enough flexibility to handle whatever you face. Ideally, a conservative plan will let you surpass your initial goals early, letting you decide whether to retire early or enjoy a higher standard of living. But even if your resources don't give you that luxury, it's still important to know what effect a few bad years could have on your plans for your golden years.
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See Robert Brokamp's entire conversation with Roger Ibbotson with a free trial subscription to Rule Your Retirement. You'll get access to past newsletters, discussion boards, and other resources for 30 days with no obligation.
Fool contributor Dan Caplinger has saved for retirement for 20 years. He doesn't own shares of the companies discussed in this article. The Fool's disclosure policy will help you every step of the way.
