A few days ago, I was running some errands and listening to a real estate guy on talk radio. He was arguing about investments with a caller and along the way, he made a statement that stuck with me.
He said that if you go back and look at the history of the stock market, it’s returned about 10% a year and that we should project that much going forward.
That number stuck with me. It seemed a little high, but I wanted to check it out. I’ve called out some financial gurus for projecting unrealistic investment returns in the past, after all – I think Dave Ramsey’s prediction of a 12% annual return on your investment is overoptimistic.
It turns out that the talker was right.
If you go back and look at the average annual change in the Dow Jones Industrial Average over the last 100 years – here, have a look – you’d find that the stocks of those thirty big American companies rose between 6% and 7% a year over that period.
It’s better than, that, though. If you also include the reinvestment of dividends over that history, the dividends have averaged somewhere between 3% and 4% a year over that period.
So, if you add those together, over the last 100 years, on average, your investment in the Dow Jones Industrial Average have risen just about 10% a year, assuming you reinvested the dividends.
Now, I’ve talked many times about why I use a 7% figure when calculating investment returns going forward. It’s the number that Warren Buffett recommends.
So, why not use that 10% number going forward?
The big reason is inflation.
If you go back and look at the history of inflation rates in the United States, you’ll see that they look remarkably stable over the last thirty years or so. From about 1984 onwards, rates barely poked above 4% and never poked above 5%. In fact, they’ve often been lower than that.
If you go back further, though, inflation goes crazy. You see years with 10% or more inflation in the early 1980s, then in the mid 1970s, then cropping up quite regularly before that. Go back into the 1920s and 1930s and things go absolutely bonkers, with years that have 20% or more inflation and then years with serious deflation, too.
The average, over all of that, comes out to a little less than 5% by my calculations.
So, if you figure over the long history of the stock market that the returns have averaged 10% but 5% of that is eaten by inflation, you get a real return of 5%.
Buffett’s prediction? He predicts a 7% annual return, but with only 2% inflation. If you average 7% but 2% of that is eaten by inflation, you get a real return of, again, 5%.
It’s all about inflation. Buffett believes that inflation will be low, thus the percent return on investments will be low. However, when you dig down, the real return really isn’t any different than it has been over history.
When I say I’m sticking with Buffett’s prediction of the stock market, I’m actually sticking with Buffett’s prediction of inflation.
That’s why I use a 7% number going forward, instead of the 10% suggested by the radio host or the 12% suggested by Dave Ramsey. It’s because, in truth, we’re all predicting the same thing out of the stock market – 5% real returns after inflation is taken out. The difference is inflation – and I trust Warren Buffett’s prediction of inflation more than I trust the guy on the radio or Dave Ramsey.