Updated on 07.15.11

Unrealistic Returns in Personal Finance Writing

Trent Hamm

This is an issue that I’ve discussed a few times in reader mailbags, but I continue to receive so many questions about it that I think it needs to be thoroughly discussed.

Over and over again in personal finance writing, you’ll find references to investment returns on the order of 10% to 12% per year (and sometimes even higher).

Over and over again in his books, Dave Ramsey makes statements like “Invest the $200 difference each month at 10 percent for the next seven years of the car loan. That $200 a month will grow over those seven years into $24,190.” (from The Total Money Makeover Workbook, emphasis added).

Entire books, such as Millionaire By Thirty by Douglas, Emron, and Aaron Andrew, proudly proclaim that rates of return as high as 15% are not only possible but probable over the long haul.

These are just two examples among many. The reason is that there’s a lot of reward in suggesting amazing stock market returns. It makes your financial plan, whatever it might be, look brilliant. You can suggest almost any old ludicrous thing, but if you’re eventually putting it into an investment that returns 12% a year for a significant period, well, your “plan” turns people into millionaires like it’s nothing!

Too bad it doesn’t really work that way.

Over the last decade, the stock market (as estimated by the S&P 500, an index of 500 stocks) has returned about 3% annually. It’s not been the best decade, with two strong downturns in it (2001-2002 and the almost apocalyptic 2008), but it’s an extreme far cry from 12%.

The housing market was producing returns of around 15% per year for the first part of the past decade. The last part? More on the order of -15% per year.

If there’s anyone I’d trust to make long-term calls on the stock market, it’s Warren Buffett. In his own words: “I would expect now to see long-term returns run somewhat higher, in the neighborhood of 7% after costs.”

Here’s the truth. You can sometimes stumble on investments that return 10-12% – or even better – for a few years. Eventually, however, there’s a correction. Speculators get out. People head for the hills. The reason is that the investment becomes overpriced.

(Warning: economic theory approaching. If you’re uninterested, skip this paragraph.) Things increase in value because it produces more than it once did. Most of the time, this is due to an increase in productivity. According to an awful lot of metrics and studies, human productivity does increase over time, but it doesn’t increase annually at a rate of more than 7%. If anything, it increases at a slower rate. (Productivity is difficult to accurately measure.) If you add productivity and inflation together in a very stable economy, you’re probably getting somewhere close to 7%, maybe a bit higher. In other words, the natural value of something fueled by human ingenuity’s actual value increases at a rate less than 7%. When something begins to gain value at a faster rate than that, you’re witnessing a bubble in action. There are speculators involved and, by the time you’ve heard about it, the speculators are usually itching to take a profit.

Add all of these factors together and I think Buffett’s long term prognosis is accurate. I would use 7% annual returns as my long term estimate for an investment with the risk level of the stock market. You might be able to beat that annual return over a short period due to luck, but volatility will eventually eat that return up. You might even be able to beat it over the long term, but you’re taking a lot of risk to do that.

Because of this, I’ve recently started sticking to 7% annual returns for my long-term financial estimation. I calculate a 7% annual return on my retirement portfolio for a long while, eventually going down to about 4% as I move it into secure stuff at retirement age. I use a 7% annual return for every bit of long term savings. I use less than that for short term savings, usually basing that on my current savings account rate, with the advantage that short term savings is essentially riskless. I would suggest you use similar estimates in your long term calculations and be very wary of people proclaiming plans with much higher returns involved.

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  1. Dave Ramsey is notorious for his highly inflated stock return statements. He does a lot of damage in my opinion because people do listen to him and often fail to check up on the facts.

    I’d have to agree with you. I think 7-8% is probably a more reasonable assumption if you’re trying to plan for the future.

  2. Ryan says:

    I use 6% in my projections.

    You hit the nail on the head with Ramsey’s sketchy math. On the one hand, he rails about how bad it is to pay 6% interest on loans, and then turns around and runs his projections for wealth growth at 10-12%. However, in his world, why would you ever prepay loans when the market will return 12%?

  3. Adam P says:

    Dave Ramsey’s 12%, and a lot of other gurus use ridiculous numbers from the 90s bull market that make me sick to read now. Like 10-12% is GUARANTEED in order to make their points seem valid and trick you into following their advice.

    The advice they give is usually very good, just don’t lie to make it sound better than it is. Trust the reader to be smart enough.

    Thankfully, I think after 2008 we don’t see too many new books/blogs saying to expect returns over 10%.

    7% or even a bit lower is probably the way forward.

    By the way is the 3% return before or after the crash of the last few weeks? I’m down about 15% on the year and all I had were equity and bond index funds (with low MERs, of course).

  4. Nick says:

    I’ve only been in the workforce for 4-5 years now, but it seems like -7 to -8% is much more likely.

    I’m joking of course and agree that things normally level out over the long term. 10% is way to high for an estimate I think.

  5. Kevin says:

    I totally agree. Ramsey is notorious for his incredibly unrealistically optimistic expectations. In his podcast, he consistently uses 12% to do his calculations. He even decries critics as being stupid, saying stuff like “Don’t tell me it can’t be done, because that’s the return I’ve been getting, and I’m not even trying. 12% is EASY.”

  6. Benjamin says:

    Past returns do not guarantee future returns, but over the last 110 years (1900 to present) the nominal return (before inflation) of the stock market has been about 11.1%. Adjust for inflation (or “real” rate of return) the stock market has returned 8% over this time period. This is where we get the standard 3% inflation rate average.

    I believe Dave Ramsey’s projections are very much influenced by the 80’s and 90’s during a time in which the Dow went from 1000 (1980) to over 10,000 (by 2000). Although he got burned in real estate over this time (with high inflation and changes in the US tax code). I do believe Ramsey’s projections are nowhere near reality.

    For one, technology has contributed greatly to the prosperity from 1980 to 2000 and I just don’t see any new innovations coming along in the near future that will have such a positive effect on the “exaggerated” returns of the stock market enjoyed over the 80’s and 90’s that have greatly skewed total returns of the stock market upward over the last 110 years.

    In order for us to get back to 11 to 12% returns over the next few decades, we’ll need to see some truly epic innovations occurring. The only place I can really see epic innovations occurring are in alternative energy, energy efficiency, and related fields.

    But I just don’t think there is enough interest in the venture capital market to bring capital intensive alternative energy projects to scale where they can compete with oil, gas, diesel, etc.

    One can only hope though! Sorry for the rant…


  7. Brian Carr says:

    Thank you for addressing this! Personal finance writing needs to be adjusted for the times. I fear the historical 8 to 10 percent returns in the stock market will be nothing more than a distant memory. More or less the 2000s were a lost decade and we’re off to a not so good start in the 2010s.

  8. Crystal says:

    What a timely post! I just finished reading “Millionaire by Thirty” a couple days ago and I thought, “What a waste of my time!” The advice to get an interest-only or ARM mortgage, and then take the extra money and put it into an 8% savings account is ridiculous. My savings account gets me 1%.

    And here’s the kicker… the book went on to tell you buy whole/cash life insurance as an investment vehicle. What a bunch of garbage.

    At least I’m intelligent enough to discern what I am reading, and not just soak it up as truth. Like a PP, I wonder how many people just blindly follow Ramsey and others, but don’t think research the facts for themselves.

  9. Anne says:

    Thanks for addressing the issue of inflated, imaginary rates of return. When doing my long-term financial planning, I use 7%. It doesn’t paint as pretty a picture but I think is much more realistic. And if my rate of return is higher (over the next 25 – 30 years)? I’ll be that much better off.

  10. Johanna says:

    Thank you for addressing this point. The really important question, which I hope you’ll also address sometime, is: What does this mean for the amount you need to save to reach some particular goal?

  11. Jonathan says:

    After reading this a couple of times I’m not clear if Trent is using the 7% as an inflation-adjusted return or an actual return. Any thoughts from other readers?

  12. JS says:

    I used Liz Weston’s columns and Suze Orman’s Money Book for the Young, Fabulous and Broke when I was first learning about retirement planning, and they both gave 8% as a figure to use. I’ve also started using 7%, but I’m glad I stumbled upon them first rather than Ramsey.

    I also use 4% for my post-retirement investments and assume that I won’t be getting Social Security (I’m in my late 20’s) when doing long-term planning, and I assume I earn 0% interest on my savings account when doing short-term planning. I’d rather be surprised by a windfall than a shortfall.

  13. Johanna says:

    @Jonathan: It’s the nominal return (i.e., not adjusted for inflation). Trent talks about this in the “economic theory” paragraph, where he estimates that “human ingenuity” (i.e., economic growth) plus inflation equals a 7% growth rate. I don’t think that’s quite right – the rate of return of a stock investment equals (I think) economic growth plus inflation plus dividends (everyone seems to forget about those) – but he’s right that inflation is a big part of the rate of return.

    @JS: Based on those assumptions, how much do you figure you need to save for retirement? When I run the numbers based on the same assumptions, the outlook is really pretty depressing.

  14. Rick Francis says:

    >In order for us to get back to 11 to 12% returns over the next few decades, we’ll need to see some truly epic innovations occurring. The only place I can really see epic innovations occurring are in alternative energy, energy efficiency, and related fields.
    The problem is that epic innovations are pretty hard to predict. A breakthrough in a very obscure area could end up changing the world, and no one- even the people working on those technologies today really knows the full implications they could have.
    Consider the internet- it was originally developed as a way to communicate if there was a nuclear war. Then it became a way for research centers to communicate, and then in the 90es it changed the world.
    I’m sure we haven’t seen all of the changes that the internet will bring about yet. I can think of several areas beyond energy that have huge potential that has been hardly tapped: Robotics, biotechnology, nanotechnology, artificial intelligence, etc.
    I’m sure that there are others- if anything I would be surprised if there wasn’t at least one epic innovation in the next 20 years.
    Beyond technological innovation what about social change- if India and China develop a significant middle class with spending power won’t that drastically improve existing companies’ profits, just by increasing demand for their goods and services?
    I think it is a bad bet to estimate that the future will be what we can readily predict.
    To be safe use 7% or maybe even 6% when calculating how much to save… but the next decade could hand us a 10 or 12% APR for stocks.
    -Rick Francis

  15. tentaculistic says:

    Huh, looks like I’m pretty pessimistic, I usually guesstimate 5% returns. Must be why my retirement planners show me eating dog food when I’m old :)

  16. Joan says:

    Trent: This is a great post, I’m glad to see a realistic (altho, it still seems a little high) approach to this issue. My son set us up with an (expert?) to invest in term insurance and stock. The expert? wanted us to lower tax deductions, 401K deductions, etc. in order to pay for what he was selling. He did some fancy math which sounded good; but of course he wanted a signature on the dotted line right now. I figure if something is really good, it can stand the light of day and some real thinking. Conclusion, we didn’t buy, the stock market tanked and we would have lost all the money he wanted us to give him. At the same time, the 401K being handled by venture just kept going down, so fired venture, did own stock selections and made a little money, instead of losing all of it. Moral: Listen to experts, but make your own informed decisions.

  17. Lou says:

    I’ve used a 5% projected rate of return in my planning for the past 30 years, and continue to assume that I will take my pay out in retirement (which is where I am now) at 4%. That 4% means my “paycheck” has decreased each of the past 3 years, as my capital was affected by stock market swings. And my capital is far less than it would have been had I not been forced by disability to leave employment 7 years ahead of schedule. I haven’t missed a hot meal.

    Save as much as you can, assume a low rate of return, and assume that disability insurance and long-term care insurance will provide much in the way of headache and little, if any, cash.

    Let me suggest a tip I never see anywhere & probably you won’t be able to use for at least 4-8 years. My best rate of return at the moment is in treasury I-bonds bought in 2001.

    For those still doing long-term planning, US treasury bonds bought with about half of my then emergency fund in 2001 continue to accumulate and compound at 8%, while all my other investments are nearly static. Keep a cash reserve, and in inflationary times (which WILL come again) put as much as you can into 30-year treasuries. Despite the current hoo-ha, T-bonds do offer benefits to long-term planners.

  18. Albert says:

    If the stock market has returned 11.1% average over the last 110 years, why is 10% hard to get? Remember not only has there been an increase in the 1980’s through 2000, but let’s not forget the great depression and a few recessions to boot. So doesn’t that average itself out?

  19. Jackowick says:

    @Johanna “What does this mean for the amount you need to save to reach some particular goal?”

    I’ll do the punchline first:
    “It means save more.”

    Now the broader: I usually took the “suggested projection” returns during any time and halved it to motivate myself. For example, in the late 90s/early 2000s, I would use 7-8% as my target growth rate. Now I use about 3%. This will all pick up and turnaround. The signs right now are really, and I mean really, look at it, far better right now than in the last recession. We are stronger underneath. We have recessions frequently in our history, we have to remember the last recession was historically significant, and if we do drift into a second “double dip”, that doesn’t mean we’re going into the same bad place. Companies have stripped their staff to the minimum. If a company needs to strip more costs off the books, it has to contract businesses or go under, and there are many cash-heavy companies (and banks) now that can weather a storm or will buy up the sliding businesses.

    That’s not painting a rosy picture, it still talks about companies going under, but we’re not in armageddon. Not even close compared to the Great Depression and the (by today’s standards) conservatively measured 25-30% unemployment. I’m not talking about the “not seeking work people” either, those were also not included in the 25-30% back then the same way we’re not including them in our 9-10% ranges.

    The irony I think is that people have learned that cutting back and saving isn’t something you do for the lean times, when you most need it, it has to be a lifetime plan. And I plan on 3-5% returns for the rest of my life!

  20. Steve says:

    The problem with Dave Ramsey is not that he assumes 12% returns, but that he assumes 12% *risk free* returns. E.g. He says you can live off 12% of your investments indefinitely (which studies have shown is simply not true – the max is closer to 4% or you’re likely to run out of money).

    Long term the US stock market has returned something in the ballpark of 12%. If you think that will no longer be true in the future, you at least have to support your statement with some kind of evidence of or argument about what has fundamentally changed. “There has been zero or negative growth in the last decade” is not such evidence; the market took 20 years to recover after Black Tuesday, but still grew at 12% long term. “Warren Buffet said so” is the appeal to authority fallacy – admittedly an impressive and relevant authority.

    Alternatively, you could make a case for saving enough so that if returns are indeed only 7% (or whatever number you want to make up), at least your basic living expenses are covered. Then if returns are higher you can live a little more freely.

    Basically, market sentiment is negative right now, but that does not prove that long term returns will be lower.

  21. Albert says:

    I agree with Steve, but I would use the 12% average to grow my investment over time, and then when I’m ready to start withdrawing move it into a more conservative investment; something that will preserve my capital. Over long period of time I should be able to get an average of 11.1%, or better if I pick right.

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