One Sentence Summary 5% return on investment is the best guess I have for the stock market over the next 40 years.
Further Reading Read my ebook to see how this concept applies to your decision about college.
Explanation In my ebook, Should I Go to College?, I say the money you invest in your college tuition should have a higher expected return on investment (ROI) than the next best and safe investment, which I say is the stock market. This is mostly an intellectual exercise to get you to think about the value college should have to you, but I personally would have invested the money I saved into the stock market had I not gone to college. You are free to do the same if you are comfortable enough.
The expected rate of return I use for the stock market in my ebook is 5% (adjusted for inflation). Where did I get this number?
It is impossible to predict your investment returns in the stock market, just like it is to predict your future career earnings after college. The best thing you can do is approximate based on what data you have.
When it comes to my expected rate of return with the stock market, I use a mixture of historical trends and Jack Bogle’s (a famous and influential money manager) method.
According to Investopedia, the average historical rate of return for the S&P 500 is 7% when adjusted for inflation. I think of that as my reasonable best case scenario.
Jack Bogle’s method is a bit different. He relies on past performance, but does so using more specific measures such as:
Don’t worry. I’m going to explain what all of those are.
In my ebook, I explain that a dividend is a portion of the profits that companies pay you if you own their stock. So a dividend yield is merely:
Earnings growth is based on historical trends. This one is subject to debate, but many people would say a safe expectation is that company earnings for the overall American economy will grow 6%. Inflation is usually expected to be 2-3%, so that makes actual earnings growth to be 3-4%.
P/E ratio means price-to-earnings ratio. This shows how much money you have to invest in a stock in order to get a certain amount of earnings.
P/E is the most common formula used to value companies because of its simplicity. The lower the P/E, the more ‘bang for your buck’ you get when you invest in a stock. (Before you go out buying stocks with P/E’s of 1 or 2, read up more why it can be a misleading formula).
How does Jack Bogle, one of the most respected and honest men in the finance industry, use these variables to estimate his returns?
Using this very simple formula:
In this video interview here, he expects the overall stock market to have earnings growth to be 5% and dividends yields which are about 2% to create a 7% investment return. He expects P/E for the overall stock market to return to its long term average of 15. That is a 3% drop.
So his overall expected return prior to inflation would be 4% annually. Now the typically safe inflation rate to expect is 2-3%, so that means his expected return could be 1-2% every year.
That’s not too good. That means if you invested a $100, you would have $101 to $102 a year from now.
Now this is just his estimated return for the next decade. If you take this formula and use it over 40 years, you get a far better number.
For the P/E to return to it’s normal number of 15, it would take 0.63% off of our yearly returns over the next 40 years (which is my expected retirement date).
So 2% dividends, 3-4% earnings growth (after inflation), and taking off .63% to adjust the P/E.
Return = 2% + 3% or 4% -.63%
Your expected return would be between 4.37% and 5.37%. For a nice round even number, I just go with 5%.