The challenge is, while the data I’ve just shared may be accurate over very long periods of time, it tells us nearly nothing about what to expect in any given year, or even in any given decade. For example, while the average equity risk premium across the past 118 years may have been a little over 4%, the story changes dramatically if we look at rolling 10-year periods during that same timeframe.

In the US, stocks have underperformed Treasury bills 15% of the time over 10-year periods going back to 1926. The same is true for Canadian stocks going back to 1970. Ten years is the blink of an eye to the stock market, but investors tend to evaluate their returns at least annually. For them, a decade is an excruciatingly long time to wait for positive, risk-adjusted performance. Even if their retirement is decades away, many investors don’t have the patience to see it through.

Even considering one year at a time, the dispersion of annual stock returns is all over the map. I don’t have data going back to 1900, but I do have it going back to 1970 for Canadian, international, and US stock market indexes. In that 47-year period, compound average returns (after Canadian inflation and in Canadian dollars) were 5.22% for the S&P/TSX Composite, 5.26% for the MSCI EAFE, and 6.96% for the S&P 500.

That’s pretty close to the 5.2% long-term average for global returns cited above. But, in all three markets during those 47 years:

The exact average annual real return was not earned in any single year in any of these markets. Annual real returns ranging between +3% and +10% occurred only 11 times in Canada, 6 times in the U.S. and 7 times internationally. Annual real returns somewhere between –8% and +15% occurred about half the time. That means the other half of those 47 years saw either very high or very low annual returns. Source: What’s a normal stock return?

Allowed Annual Spending

To calculate your own number, take the average of 8% of your invested assets (including your retirement accounts; that’s still very much part of your net worth) and your post-tax annual income (or, if you have really high income or have super aggressive goals, use half your salary). That’s a spending amount that’s in line with both your income and your wealth. For example, if you make $175,000 but only have $50,000 invested, you’d take the average of $175,000 (income) and 8% of $50,000 (investments): $89,500 of annual spending money and $85,500 of “saving” money.

The idea is that—as you increase passive income from your wealth and decrease active income from labor later in life—you reach the point where you could live on the average of $0 of active income and 8% of your investment portfolio (which ends up being the safe withdrawal rate of 4%).

Source: Katie Gatti Tassin

However, I don’t love this approach, as it assumes an 8\% safe withdrawal rate. I’d actually expect something closer to 5\% for a less optimistic calculation (also see numbers above).

[Share on twitter]

21 Dec 2020 - importance: 4