Investors’ Return Expectations: A Closer Look
Natixis Investment Management recently conducted a survey among individual investors, specifically targeting those with at least $100,000 in investable assets. This study explores various topics, with a focus on long-term return expectations. The latest survey yields some puzzling results. U.S. investors anticipate a long-term stock return of 12.6% each year. This figure is over and above inflation.
Interestingly, this number has decreased from the 15.6% that was reported in 2023. Nevertheless, it remains high compared to historical averages, which could have unintended consequences.
Potential Causes: Recency Bias
When examining data over several years, a 12.6% return might seem somewhat reasonable or even prudent. For context, the nominal returns of the Morningstar U.S. Market Index approached 25% in both 2023 and 2024, showing a small increase of about 3.4% in 2023 and another 2.9% in 2024.
Furthermore, if you take the arithmetic average of nominal returns from 1926 to 2024, the results hover around the 12.6% mark—12.4% to be precise.
Another factor might be that those who responded to the survey aren’t fully aware of how inflation impacts their returns. Most of the returns reported are nominal and don’t account for inflation. On the flip side, actual returns do consider inflation adjustments, which usually result in much lower figures. To illustrate, an actual (post-inflation) return of 12.6% could approximate a nominal return of around 14.9%, assuming a 2% inflation rate.
A More Realistic Expectation
A more accurate estimate for returns adjusted for inflation is closer to 7.3%. This figure comes from the IA SBBI U.S. large-cap equity inflation-adjusted return index spanning 1926 to 2024.
So, why does this number differ significantly from the aforementioned simple average of 12.4%? Primarily, it’s influenced by an average inflation rate of about 2.9% over the same duration. Additionally, it derives from a geometric mean, which sheds light on how returns interact over time. For instance, if you invest $100 and lose 50%, then gain back 50%, you don’t break even. Instead, you’d actually end up with $75, resulting in a total return rate of -25% after the first year. This dynamic illustrates that geometric returns tend to be lower than straightforward averages, as losses, while less frequent, create more significant setbacks due to compound interest effects.
The Importance of Realistic Expectations
What could happen if investors set their sights too high when it comes to returns?
One clear risk is that such lofty expectations might lead to misguided financial strategies. Consider someone saving for retirement with a target of accumulating a $1 million nest egg in today’s dollars. If they assume a 12.6% post-inflation return, they would need to save about $250 each month or $3,000 annually to reach that goal. However, with a more grounded return estimate of 7.3%, that monthly saving requirement skyrockets to approximately $772, or $9,264 annually. Essentially—this means needing to save over three times more.
Furthermore, relying on overly optimistic return assumptions can result in excessive spending down the line, especially if they start drawing from their retirement assets. Personal finance experts often recommend unrealistic withdrawal rates, like using an 8% withdrawal rate for retirement costs.
Sticking to these unrealistic expectations can backfire as well. If actual returns end up being lower—something that seems likely—those hoping for better may become disillusioned and withdraw from the stock market completely. It’s also crucial to remember that enjoying the long-term benefits of stocks isn’t without its challenges; there have been periods, like 32 out of the last 99 years, where stock returns were negative. In fact, historical data shows negative annual returns, such as a loss of 1.4% during the 1970s and a 2.6% annual loss during the early 2000s.
Final Thoughts
None of this should diminish the remarkable potential of stocks. A long-term return rate of 7.3% is still significantly better than what many other asset classes, like bonds and cash, can offer. However, it raises a red flag about the disconnect between what investors expect and what they can realistically achieve from stock market returns over time.
