What’s the average annual return you expect to get from your investments between now and retirement? Here’s the bad news: if you’re anywhere near as optimistic as the average investor, you’re likely to be disappointed. One American financial newsletter editor recently asked his subscribers for their forecast “net-net-net” return – in other words, what they expected to make each year after inflation, trading costs and tax. The average answer was 6%.
To which Jason Zweig in The Wall Street Journal asks: “What are we smoking and when will we stop?” It may sound low, but 6% is in fact hugely optimistic. According to Ibbotson Associates, US stocks have earned an average annual gross return of 9.8% in the past (the figure for British stocks is slightly lower).
There’s nothing wrong with that. But then you have to account for the fact that inflation, historically, has knocked around 3% a year off returns. Expenses such as trading charges and bidto- offer spreads knock off another 1%- 2%. Then there’s tax, which on shares in Britain includes stamp duty (at 0.5%), capital-gains tax on profits (at 18%) and income tax on dividends (at up to 40%). In the end, the true “net-net-net” return is more like 4%. And that’s if you’re fully invested in shares. Split your investments between shares and safer investments, such as bonds, and that figure could drop to 2%. Why does this matter? Because if we have hopelessly unrealistic expectations about how rapidly our savings will grow, then we’re probably saving too little for our retirement. The end result is “more years working rather than putting our feet up”.
And this over-optimism afflicts ‘expert’ investors too. David Salem, president of the Investment Fund for Foundations (which manages around $8bn), asked its
clients this question: “what guaranteed annual ‘net-net-net’ return would you require for the next 50 years, in exchange for all of your current wealth?” The average answer was 7.4%. In other words, despite all the evidence to the contrary, these investment professionals believed they could earn at least 7.4% by themselves – if not they’d have named a lower swap rate. One investor even demanded 22%, enough to turn $100,000 into $2.1bn. Yet when the same question was put to London Business School Professor Elroy Dimson – an expert on the history of market returns – he replied with just 0.5%. So what to do?
First, assume any financial adviser who claims to be able to make say 6% a year after costs is either “a fool or a crook”, says Zweig. Ask potential advisers the swap question. What rate would they guarantee you in return for all of your existing assets? If nothing else, it might focus their minds on the returns they believe they can genuinely achieve.
