This is part 2 in a 7 part series on designing your portfolio. In part 1, we discussed how to set a specific goal for your portfolio and introduced the “future value” spreadsheet function. In this part, we’ll begin discussing the concept of asset allocation and further explore the future value function and especially the relationship between how much you need to save, your portfolio return, and time.

## How Long Will it Take to Reach Your Investing Goals?

Open up your spreadsheet again and put this future value function into a cell.

=FV(5%,20,-60500,0)

=2,000,490.22

This function says that if you start with nothing (0) and save $60,500 a year for 20 years, and earn 5% after-inflation each year, that after 20 years you’ll have $2 Million in today’s dollars. Now, $60K seems like an awful lot of money to save each year. I mean, you’re only making $200K, you’ve got a fat mortgage, 2 kids in private school, a high tax bill, and payments on the Porsche to make, right? So what other options are there to get to that $2 Million figure?

The four terms are all dependent on each other, but this concept is so important to your investing plan that we can’t spend too much time on it. Let’s say you can only save $30K a year. Let’s assume you still don’t have anything to start with and you still earn 5% real on your investments. How long is it going to take to get to that $2 Million figure?

=FV(5%,30,-30000)

=$1,993,165.43

An extra 10 years. Hmmmm. Now you’re deciding between that big house with the expensive mortgage versus working 10 years longer. What other options do we have?

Well, you could get an inheritance, so let’s say you have $300K in your retirement accounts already. How long do you have to work now if you save $30K a year and earn 5% real?

=FV(5%,21.75,-30000,-300000)

Now you get to $2 Million in just 21 years and 9 months.

But what if you OWE $300K in student loans (let’s assume 0% interest, just to keep things simple) and really want to retire in just 25 more years? How much do you need to save/use to pay down loans each year?

=FV(5%,25,-63200,300000)

It turns out $63,200 per year.

You can play around with this function yourself for a little bit just to get an idea of what is possible.

## What About Investment Return?

Well, that’s pretty cool, you say. Don’t you feel empowered now? Now you too can generate all those fancy charts and graphs financial advisors like to wow you with.But there’s one factor in that function that is much harder for you to control — your return. Wouldn’t it be wonderful if you could just double your return?

For example, let’s say you only want to save $30K a year, you have nothing now, and you still want to retire in 20 years? What kind of return do you need? =FV(11.3%,20,-30000,0) 11.3% It seems a lot easier to just get that 11.3% return than to sell the Porsche or live in a small house, doesn’t it? Why not just do that?

## Unpredictable Nature of Market Returns

The source of your return is the financial markets. Market returns are impossible to predict, much less control. This goes for the stock market, the bond market, the real estate market, the commodities market or any other market you want to invest in. You can control the amount of risk you take, but that only has a moderate amount of correlation with your actual returns. It is important to understand the concept of expected returns.

Your expected return is what you expect to get for a given level of risk, on average, over many years. Even over many years, there are no guarantees, especially given the complex economic and political changes that occur frequently around the world and in your own city and country. But if you have no idea what to expect, you can’t possibly estimate how much you need to save.

## Historical Returns

One source you can look to for estimating your returns is the past. As every investment prospectus is required by law to mention, past returns are no indication of future returns. But they do help define a range of possibilities.

### Realistic Stock Market Returns

Let’s take a look at the US Stock Market for instance. If you invested in the low-cost Vanguard 500 Index fund since its inception in 1976, your average annualized nominal (before-inflation) return would be 9.51% from 1976 to 2020. Inflation from October 1976 until 2020 has averaged about 3.51%. So the real return of the US Stock Market (including dividends and subtracting out very low investment costs) is 6.00%.So if the future is like the past, and you invest in a 100% stock portfolio, you could use an expected return of 6.00% in your calculations. Note how different this number is from the 11.3% discussed above. That really demonstrates how unrealistic the plan to only save $30K per year and to retire in 20 years on $2 Million is. Even if you got this 6.00%, you would fall $896K short of your goal.

### Bond Market Returns

What about bonds? Vanguard started its “Total Bond Market Fund” in 1986. The average annualized return since then has been 5.93%. Inflation over that time period is 2.58%, leaving a real return of 3.35%. If we use that as an expected return then a portfolio of 50% stocks and 50% bonds would expect a return of 4.68%, not counting any rebalancing bonus (more on that later.)

We do have more data on long-term stock and bond returns, with the best data set going back to the 1920s and some even going back a couple of hundred years. But those numbers aren’t all that much different than what we’ve discussed above.

## Theoretical Returns

Another way to look at returns is from a theoretical perspective.

### Theoretical Bond Returns

If a bond investor really expects 4% real returns going forward from this point, most authorities would tell him he’s crazy. Part of the reason for the relatively good bond returns over the last 22 years is that interest rates have been falling, giving bond returns a nice tailwind. At the end of 1989, 10-year treasury bonds were yielding about 8%. Now they’re yielding less than 2%. The best predictor of future bond returns is the current yield, and that’s a nominal (before inflation) number. Given current inflation rates (near zero in June 2020 when this post is updated), that means our current expected real bond returns are -1 to +1% range. Pretty depressing huh.

### Theoretical Stock Returns

You can also estimate real stock returns theoretically. The most common way is the discount dividend model. You basically add the expected dividend yield to the expected GDP growth. There is a speculative factor as well, but over long time periods, that can generally be ignored. Current yield of the S&P 500 is almost 2%. Economists are estimating around 3% for the long-term GDP growth. Add those together for a 5% real return.

Using these theoretical returns, we can calculate the long-term expected real return for a 50% stock, 50% bond portfolio at 2.5%.

## Take More Risk For a Better Investment Return

Now, there are ways to take on more risk in hopes of getting more return. You can invest in a stock-heavy portfolio and even include riskier stocks that theoretically have higher expected returns, such as microcaps, small value stocks, or emerging market stocks.

Real estate also promises some higher returns, especially when using significant leverage.

But the bottom line is that the expected after-inflation return number you should use in your portfolio return calculation is somewhere between 2 and 7%. If you (or your advisor) are making calculations using 10% or even 12%, your plan is probably doomed to failure.

## You Need to Save More Money

Let’s return again to the future value function. If you want $2 Million in 25 years and have nothing now, you’ll need to save somewhere between $65,500 (2% returns) and $31,700 (7% returns) per year. The riskier your portfolio, and the more optimistic you are about the future economy, the less you can save. But putting away $20K a year just isn’t going to cut it, and $50K might not even be enough.

So step one in designing a portfolio is setting specific goals. As you begin to implement an asset allocation to reach those goals, it is important to realize the relationship between how much you need to save, and how much of the “heavy lifting” your portfolio will provide through its compounded returns. See why I said, “If you don’t know how much you need to save you won’t save enough?” A comfortable retirement requires far more savings than most people think.

Part 3 will discuss how to choose asset classes to include in your portfolio. If you want to read the whole series, check out these links:

- Part 1: Define Your Investing Goals
- Part 2: Return vs Savings
- Part 3: Choosing Asset Classes
- Part 4: List of Asset Classes
- Part 5: Asset Allocation
- Part 6: Implementation
- Part 7: Maintaining the Asset Allocation

*What percentage of your income are you saving for retirement? What after-inflation return number are you using to calculate your future nest egg? Comment below!*

Well put. Most individuals never recognize how much money they really need to set aside for retirement. As you mentioned, it is much easier to continue driving nice cars and living in a nice house.

This is a great exercise for people to grasp how much they need to save, given select rates of return: 2%-7%. Most people are shocked that they’re not on track, yet meanwhile they’re only saving 5% of their gross income.

The good news is that many doctors only need 30% of their pre-retirement earnings in retirement (not the traditional planner recommendation of 70%.) But even getting that requires a higher savings rate than most people think.

As one of the best blogs out there says: EARN, SAVE & INVEST. We have some control over our income by picking the right profession that we enjoy and negotiating the best employment deal. We have less control over our investment returns going forward. I have my doubts that stock returns are going to be as good as they have been in the past but who knows. It’s pretty certain that cash and bonds will have pretty lousy yields in the near future. If you are young and have a long investment horizon I think you should be aggressive in your stock allocation (80% or greater). You have the most control over your savings. As Mr. Money Mustache put it in his now famous post: “The Shocking Simple Math Behind Early Retirement”, you should be able to reach FIRE in 15-20 years with a savings rate of 50%. Once you reach financial independence you can work part-time and perform partial Roth conversions every year. As physicians, even a half-time job would max out your social security. If you claim your social security at age 70, it would easily cover essential retirement expenses. You could then cover discretionary expenses with systematic withdrawals from a stock portfolio.

This is the best discussion of this subject I’ve found – thank you!!

I always want to do my calculations for a variety of returns, weighted by how probable I think they each are, and I of course want those guesses to reflect by generally pessimistic view of the economy (read: my generally pessimistic nature). But other than “skew way down from the historic rate of return / what most people tell you”, I have had very little way to come up with the numbers I use. This post is a huge help!

I’m glad you enjoyed it. It’s important to realize the range of possible and reasonable outcomes. If you’re overly conservative, you’ll work too long and save too much. If you’re not conservative enough, you run the serious risk of running out of money in retirement (or never being able to retire.)

I know this is an older post, but the link to Part 1 doesn’t seem to be working. Not a huge deal, but just wanted to let you know. Thanks!

Here’s the link: https://www.whitecoatinvestor.com/designing-your-portfolio-part-1-goal-setting/

One question: In the post, for the formula you say that: “This function says that if you start with nothing (0) and save $60,500 a year for 20 years, and earn 5% after-inflation each year, that after 20 years you’ll have $2 Million in today’s dollars.”

How does the function calculate the “after-inflation” amount? Wouldn’t the 5% return (or whatever return you choose) be the rate of return that does NOT take into account inflation?

Thanks

It does it automatically by using 5% real instead of 8% nominal.

Thanks. So the 5% in the excel formula includes an assumed 3% for inflation? In other words, I would need an 8% yearly nominal return on my investments to mimic the 5% real in the excel?

That’s right.

Such a great breakdown of an important concept.

As someone at the beginning of the road to financial well being, I was initially very surprised at how much greater the impact of savings is compared to returns. I was lucky to recognize this just before becoming an attending and certainly would have made the mistake of not saving enough.

Now I have a complete financial plan with roughly 40% savings rate. 1/3 is going to paying off student debt, 1/3 to an 80/20 stock/bond portfolio (low cost, diversified, index funds), and 1/3 to direct real estate investing through cash flowing rental properties.

http://www.prudentplasticsurgeon.com

“If you don’t know how much you need to save you won’t save enough?”: Highlight this line as big as you can and tweet it to the world!

I call this the working your way backwards method to figure out your retirement goals. One of the hardest parts for me was the calculations…. I’m not the spreadsheet-y kinds. But it really isn’t hard (like you’d said all along).

For anyone like me scared of spreadsheets, I have this step-by-step with pictures of playing with FV and PMT and the others on Google sheets: https://physicianfinancebasics.com/how-much-to-save-for-retirement/

Hope it helps,

PFB

I couldn’t agree more! Great post, the spreadsheet screenshots are super helpful!

Great article!

Percentage income really depends on the income, right?

I’m 3 years into practice, 37 years old, still carrying debt, but my wife and I make about $450k.

We max out all tax-advantaged space (my 403b + 457b + her 401k + backdoor roth x2). With matching, putting away about $92k a year into these accounts. Not counting 529 or the small taxable account contributions we’re making…. this seems like plenty every time I do these future value calculations, and it’s roughly 20% of gross income. Plan is to invest more in taxable and real estate as debts are paid off but we feel quite good about the future maxing out these retirement accounts!