Assuming a realistic investment return is crucial for retirement planning. To determine a sensible default, let's examine historical data from the S&P 500, bond mixes, and inflation-adjusted returns.
Historical S&P 500 Returns
The S&P 500 has returned around 10% per year over the past century. However, to find the real return (return above inflation), we need to adjust for inflation. For example, if you invested $100 in the S&P 500 in 2000, you would have around $340 today. With 2% annual inflation, the purchasing power of $340 is equivalent to $230 in 2000 dollars. This translates to a real return of around 5% per year.
To calculate this, let's break it down: if $100 grew to $340 over 20 years, the annual return is approximately 7.2% (using the formula for compound interest: A = P(1 + r)^n, where A = $340, P = $100, r = ?, and n = 20). However, since inflation was 2% per year, the real return is 7.2% - 2% = 5.2% per year.
Bond Mixes and Diversification
Bonds have historically returned around 5% per year. A mix of stocks and bonds can provide a more stable return. For instance, a 60/40 stock-to-bond ratio could be represented by 60% of the S&P 500's 10% return and 40% of a bond's 5% return, resulting in a weighted average return of 0.6*10 + 0.4*5 = 8% per year. However, this number is sensitive to inflation.
Using the Freedom Calculator, you can experiment with different investment mixes to find the optimal balance for your retirement goals. For example, you can compare the returns of a 60/40 portfolio with a 40/60 portfolio to see how the mix affects your overall return.
Inflation-Adjusted Returns
Inflation is a crucial factor in retirement planning, as it erodes the purchasing power of your money over time. The 4% rule (withdraw 4% of your portfolio per year, indexed to inflation) is a common guideline for sustainable retirement income. To maintain the purchasing power of your portfolio, your investment return must keep pace with inflation.
Here's an example of how inflation affects your portfolio: if you have a $100,000 portfolio and withdraw 4% ($4,000) per year, with 2% inflation, you'll need a 6% return just to maintain the purchasing power of your portfolio (4% withdrawal + 2% inflation). If your return is 7%, you'll have a real return of 1% above inflation, allowing your portfolio to grow.
Why 7% is the Sensible Default
Considering historical data and the need for a sustainable retirement income, 7% is a reasonable return assumption. It's high enough to account for long-term market growth, but low enough to be conservative and account for potential downturns.
Let's consider a few scenarios to illustrate the impact of return assumptions on retirement planning:
- If you assume an 8% return and your actual return is 6%, you may deplete your portfolio too quickly.
- If you assume a 6% return and your actual return is 8%, you may be overly conservative and miss out on potential gains.
- If you assume a 7% return, you're more likely to strike a balance between growth and sustainability.
In conclusion, a realistic investment return assumption is crucial for a successful retirement plan. By understanding historical returns, diversification, and inflation-adjusted returns, you can create a more accurate and sustainable plan for your golden years. With a 7% return assumption, you can better navigate the complexities of retirement planning and make more informed decisions about your financial future.
New to FIRE? See our primer at https://freedomcalc.app/what-is-fire.
Tools worth looking at
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- Empower — Free net worth tracking, portfolio analysis, and retirement planner. The dashboard serious FIRE chasers actually use.
- Acorns — Round-ups that invest your spare change automatically. The lowest-friction way to start investing if you have been putting it off.
- Wealthfront — Tax-loss harvesting, a 5% cash account, and direct indexing once you cross $100k. Solid robo for the set-and-forget crowd.