Tuesday, August 4, 2009 7 comments ++[ CLICK TO COMMENT ]++

Newbie Thoughts: Your portfolio will double three times in your life

Your portfolio will double three times in your life.

Many readers of this blog, including possibly me, will never be good investors. I know that is not the attitude to have when you are trying to beat the market but we need to be realistic at times. Very few can outperform the markets, and, like any business—investing is a business—only a few will succeed. Even those that seem to be pretty good may start trailing off as their life changes (marriage, kids, better career, greater interest in other activities, and so on.)

I'm not saying that those that have the time and resources to pursue investing on their own should give up. Indeed, I'm not giving up. Not just yet. Rather, I think it is worthwhile considering what is a realistic outcome for our portfolios.

My personal opinion is that a good rule of thumb is to assume that your portfolio will likely double three times in your whole life! Think about that a lot and plan your life accordingly—at least that's what I'm doing. The actual outcome depends on a whole hoard of details, and is based on some assumptions, but here is how I think about it.

How Do I Arrive At That?

I am assuming that you are relatively young and have a 30 year investment time horizon. Basically, it's as if one started investing when they were 30 and "stopped" when they were 60. Obviously your details may be slightly different.

In the long run, stocks return around 8% to 10% per year; real estate is hard to measure but it returns around 6% to 8%; bonds return around 5%; and cash/gold around 2% to 3%. Given how I'm looking at someone who is starting out, I think it is reasonable to expect one to have somewhat high risk tolerance and be investing mostly in stocks. Again, it depends on the individual and it can vary.

Given the above to assumptions, which actually mirrors myself and many readers I suspect, I think a reasonable return is 8% to 10% per year. If you compound it, you will see that your money doubles every 10 years. Actually, it will double roughly every 9 years if you go with 8% and roughly 7 years if you earn 10% per year. However, 10 years is an easier number to visualize (it's basically a decade)—I am following John Maynard Keynes' suggestion to be approximately right than precisely wrong.

Since you are investing for 30 years, your savings will double 3 times.

Sample Numbers

So, if you start with $10,000 in year 1, it will double 3 times in 30 years: 10k->20k->40k->80k. In 30 years, you will end up with $80,000.

If you start with, say, $100,000 in year 1, it'll be: $100k->$200k->$400k->$800k.

These numbers are not adjusted for inflation so the $800k in 30 years might be something like $600k now. (Inflation is historically 3% per year but it is far easier to hedge against inflation now than in the past. Most businesses even rely on business models that hedge against inflation. Therefore, the contrarian in me says that everyone will be vulnerable to deflation in the long run.)

I think the second scenario is roughly how most of us, who do not have high-end jobs, will end up. The numbers may vary slightly but that's kind of how I expect myself to end up. You won't be rich but you won't be poor either. You'll basically be middle-class (but not upper middle-class.)

How About The Starting Value?

As we saw in the gold vs stocks post, the starting value makes a huge difference in any performance analysis. The same is true here.

Is it fair to assume that someone starts with a high amount, $100k, in year 1? In practice, it is unlikely that a young person (unless they had a good job or were wealthy) would have $100k to throw around on the stock market but I don't think it matters in the grand scheme of things. I am looking at case of a lump sum at the start but even we look at the realistic case of someone saving a little bit every year, you will get close to these numbers. Also, don't forget that I'm starting when someone is 30 years old. It is possible they have saved a few thousand every year in their 20's.

The important point to note is that saving early matters a great deal! (I have an upcoming post on the starting value, which is a very important point for newbies to understand.)

How Accurate Is This?

What I have described is a very rough way of thinking. It is not accurate at all. I am trying to be conservative and point out a somewhat pessimistic outcome so that one can think about their distant life. I actually think most people will end up with higher dollar amounts in the end than what I mentioned above for several reasons.

What I mentioned is a case of someone investing a lump sum and leaving it in the stock market. It is far more likely that someone will save a little bit every year for the rest of their life. If someone were adding a small amount every year, the final savings will be much higher (depends on details.) I am not considering this scenario, which is basically dollar-cost-averaging, because it is complicated and is sensitive to the savings rate (I have a future post coming up illustrating how dollar-cost-averaging, or saving continuously, produces different results.) In an ideal world, everyone should be saving as much as they can, without jeopardizing the life they want to lead.

What If You Are Bearish?

Some of the greater bears, Grizzlies and Polar Bears, may wonder if the stock market return assumption makes sense. Many macro investors I respect actually think 8% to 10% is a high limit for stocks and we may post much lower returns. Indeed, I am skeptical that we will post over 8% per year for the next decade.

However, a macro outlook doesn't impact the idea I am presenting here. In the very long run (we are looking at 30 years here), bear markets are offset by bull markets. American stocks have gone through depressions, world wars, and many other calamitous events and still posted around 10% per year. Interest rates were higher in the past and so were tax rates. Other developed markets, like Britain and Canada, have also posted similar returns.

There are obviously some exceptions such as Japan but one has to invest at the peak for returns to be low. If you do invest near peak, your returns will be lower (possibly even negative). However, the stock market is usually not (wildly) overvalued (except around 2000) so I think one's portfolio will indeed double three times over the next 30 years.


7 Response to Newbie Thoughts: Your portfolio will double three times in your life

August 4, 2009 at 8:30 PM

This kind of long-term thinking is critical, and is strangely mostly ignored by the financial media.

I put some thought into this when I first started investing, and unfortunately, I think your projections are a bit rosy for the average investor.

First of all, as a throwaway, you ignored commissions, fees, and taxes.  But let's ignore that.

My main issue with your numbers is inflation.  If we assume 3% annual inflation, then after 30 years you would need $2.42 to equal the purchasing power of $1 today.

So $1,000 invested at 10% per annum would become $17,400 nominal in 30 years, and $7,200 when adjusted for inflation.  This is close to 3 doublings of purchasing power, but I think 10%, while plausible, is a high estimate and would require a strong bull market and P/E expansion to support it.

$1,000 at 8% per annum would become $10,000 in 30 years, or $4,100 when adjusted for inflation.  Note that this is only 2 doublings of purchasing power, not 3 doublings.

This is not an argument against stocks.  In fact, inflation should scare bond-holders or cash-holders much more!

The way I think about it is that the market can have basically 4 sources of return
1)  Real Growth in after-inflation profits
2)  Distributions to shareholders (dividends & buybacks)
3)  Change in Earnings Multiples (ie P/E ratio fluctuation)
4)  Inflation

For a long-term investor, only points 1 & 2 really help.  #3 (P/E) is not predictable, and should even out in the long-run, anyway.  Gains from #4 (inflation) are not real.

So any investor looking for a market-wide return of 10% needs these 4 numbers to add up to 10% in some way.

Here's my (slightly pessimistic) projection.
1)  2% per year in Real Growth in after-inflation profits
2)  3% per year in Distributions to shareholders (dividends & buybacks)
3)  0% per year Change in Earnings Multiples (ie P/E ratio fluctuation)
4)  3% per year Inflation

This would equal a 5% real return, or a doubling every 14 years.  Do you think this is plausible?  If not, then which of these numbers do you disagree with?

Sivaram Velauthapillai
August 4, 2009 at 9:10 PM

I would agree with you that inflation, as well as transaction costs, need to be factored in if you want to be accurate. Another widely ignored item is taxes, which matter a great deal if you are investing outside a tax-sheltered account.

If I were to do a more thorough estimate, I would attempt to factor those in. However, I don't think one will necessarily arrive at a "better" answer by becoming more precise. Factoring in more factors can become just as misleading as not factoring in them. 

For instance, let's say you look at transaction costs. Well, if you buy stocks and hold them for a long time (or even as little as 2 years), your transaction costs probably won't even be 1% per year (assuming your portfolio isn't too small.) Concentrated investors definitely will have low transaction costs and even those buying funds or ETFs will likely have low costs as long as they hold them for a few years at a minimum. My transaction costs used to be high (as much as 3% per year) but I suspect they will be around 0.25% or less over the next few decades (because the portfolio will, hopefully :) , grow.)

So, should the future estimate for transaction costs use, say, 1% or 0.25%, or 0.5%, or what? What you pick will produce quite different answers. I would argue that the answer can be off even if you use incorporate transaction costs (you may overestimate it, just like ignoring it underestimates it.) I'm not arguing that we should ignore it just because I say it. Rather, I'm just saying that it gives a false sense of precision.

Similarly, if you incorporate taxes and the like, I don't think the answer necessarily gets better. Having said all that, inflation definitely needs to be factored in because it is very large (usually 3%.)

Since my goal is just a rough idea, I don't worry "that much" about being accurate. Instead, my estimate is somewhat conservative with a decent margin.

I said the portfolio will double in 10 years and that's actually an annual return of around 7.2%. If you compound that, you get around 100% in 10 years. So, it isn't really a 10% return that is required (although I like to think of it as 10% per year for 10 years.) I think the roughly 2.8% margin sort of accounts for inflation.

August 4, 2009 at 9:20 PM

Any investment can be overpriced no matter how great its fundamental value or how secure its prospects.  In the absence of a more thorough analysis, it's reasonable to suspect that investments in a market that has been rising for a long time are overpriced.  In itself that guideline isn't a signal to sell, it is a signal to make a closer examination.

Sivaram Velauthapillai
August 4, 2009 at 9:42 PM

MrParkerBohn: "Here's my (slightly pessimistic) projection.  
1)  2% per year in Real Growth in after-inflation profits  
2)  3% per year in Distributions to shareholders (dividends & buybacks)  
3)  0% per year Change in Earnings Multiples (ie P/E ratio fluctuation)  
4)  3% per year Inflation  
This would equal a 5% real return, or a doubling every 14 years.  Do you think this is plausible?  If not, then which of these numbers do you disagree with?"

I think 5% real is reasonable for the next decade but I think we'll probably get closer to 7% real (9% to 10% nominal) for the very long run (say 30 years.) We would have to enter a severe bear market (or a depression or war or something like that) to see 5% real for longer than a decade. It's possible we'll see 5% real for one decade but I would be surprised if that materializes for longer than a decade.

It's really difficult to say. I usually go with the following formula, which is conceptually similar to your method:

Total Return (nominal) = Dividend Yield + Earnings growth + Valuation change

Current dividend yield on S&P 500 = 2.7% (WSJ Market Data)
Long term EPS growth has been around 6.7% (refer to page 2)
Valuation change = 0

Total Return (nominal)
= 2.7% + 6.7% + 0%
~=6.4% real (if we assume inflation is 3%)

I agree with your thinking that we shouldn't bank on a p/e expansion, especially given how the market is not cheap right now, so I have set that to zero like you have done.

Using the dividend yield method is somewhat controversial since some argue that dividends may be misleading--but I don't believe they are wildly off. One can use earnings yield or some other measure if needed as well and I'll bet the answers will be close.

In real terms, money will double roughly 11.1 years with these numbers. This isn't as optimistic as my 'double in 10 years' case but they are slightly better than your estimate.

Daniel M. Ryan
August 5, 2009 at 12:01 AM

Another rule, that's less computation-driven but still holds up:

In your lifetime, you'll see two long-term bull markets in equities. The first is likely to catch you by surprise, but may prepare you to take advantage of the second. By the time the second comes along, you'll be older and (probably) more affluent but more conservative and less flexible. The trick is spotting when the second will be upon you.

August 5, 2009 at 3:48 AM

Sivaram, you make a critical yet very subtle, point. Whereas it is critical to start saving at an early stage, this does not imply to start investing in the stock market at an early stage. Rather, one should think hard about overvaluation, and then invest or not according to this. To name one, Buffett was for the past decade or so skeptical about the near-term stockmarket returns, and he was quite right.This is specially valid for a passive investor, of course.

This is also relate to a quote of his you mentioned a few days back, concerning the two main topics to cover in business school: business valuation and market volatility. We neglect the latter, at our risk. In fact, if I remember correctly, Graham recommended for most people dividing their investment into bonds and stocks, and buy stocks when a *trusted* source deemed them fairly valued. Buffett fills quite well the trusted, I believe. Note that this is not exactly timing, but rather a general consideration of market over/undervaluation for the passive investor, which should be most.

A final thought concerns the fact that many young Western people followed this advice of investing as soon as possible. As a result, a good part of their savings in the past decade is essentially gone. One should not understimate the incentives that banks/funds/pension plans have to sell their product in the largest possible amounts to the most people, and how easy to trick we are into buying them.

Sivaram Velauthapillai
August 5, 2009 at 10:16 AM

I concur with what you are saying but the situation is not as bad for young investors because they have the power of dollar cost averaging in their hands. I think the ones that are vulnerable are the wealthy or the elderly, who really aren't dollar-cost-averaging (even if they were, the amount they save relative to their portfolio tends to be small.)

I think market valuation is a far greater concern the older you get and the bigger your portfolio gets (relative to your savings.)

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