By Dr. Jim Dahle, WCI FounderOne of the most important concepts for an investor to understand is that of expected returns. Expected returns are, of course, not guaranteed returns, but an investor who doesn't have any idea of the range of possible future returns is likely to make significant errors in investing.
A common error is to save too little. For example, an investor who expects an investment to return 15% when it only returns 5% will save far too little to reach their goals. Another common error is to buy high and sell low. This occurs when an investor doesn't realize that a risky asset class can drop 40%, 50%, or even more over a relatively short period. The investor panics and sells their investment to a more patient investor with a more realistic view of expected returns.
How to Estimate Investment Returns
How does one estimate future returns? Probably the best place to start is in the past. If you're expecting an investment to return 20% a year but its long-term returns have been only 10% a year, you're likely in for a disappointment. The overall US stock market, the most successful one in the world over the last century, has had a return over the last 100 years of 10.46%, approximately 6.51% in price appreciation and 3.95% in dividends. That number is prior to inflation, taxes, and investment expenses. Inflation alone has been 3.18% a year from 1925-2025, so the “real” (after-inflation) return has been 7.28%. You can subtract taxes and expenses from there. You can quickly see that any adviser who suggests you rely on “10% investment returns” to reach your goals is already setting you up for failure.
Although that is common, some would lead you to believe that even higher returns are possible. Dave Ramsey, for instance, does a fantastic job helping people get out of debt. Unfortunately, once they're out of debt, he has recommended they get into “good growth stock mutual funds,” which will then return them “12% a year.” About a decade ago, there was a bust of a Ponzi scheme in my area where the investors were sucked in by promises of returns of 18% a year. If an investment is promising three times the long-term return of the stock market (which, at one point, lost 90% of its value), you can bet it will be at least three times as risky.
Where Do Investment Returns Come From?
To make matters worse, many investing gurus have cautioned people that the future expected return of the US stock market is far lower than the past returns. To understand why, you need to understand where returns come from. John Bogle, in his investment classic Common Sense on Mutual Funds, teaches that returns come from three components: the dividend yield, the earnings growth of the underlying companies, and the speculative return. Over the long term, the speculative return becomes a non-factor. At times, people are far too optimistic about the stock market, such as in 1999, and they bid stocks up to ridiculous prices. At other times, such as late 2008, people are far too pessimistic, and stocks sell at a discount. But over the long run, these excesses cancel out each other.
So, long-term returns really only come from the dividend yield and the growth of earnings. Remember that from 1925-2025, about 40% of the return came from dividends (3.95%). Now, think about the current dividend yield of the US stock market, 1.2%. Assuming the earnings growth of the companies that make up the US stock market remains about the same in the future as it has been in the past, long-term returns going forward look to be about 2.8% lower than they were in the past. Is that assumption reasonable?
Well, US economic forecasts for the next several years call for growth of 1.5%-2.7% per year. Luckily, that's an after-inflation number. If the current dividend yield is 1.2% and expected growth is 2.5%, a reasonable long-term expected real return on the overall US stock market would be 3.7% going forward.
Meanwhile, the current yield of the US bond market is 3.8%. Unfortunately, that's a nominal, pre-inflation number. If you subtract out an expected 2.4% for inflation, you're left with a 1.4% real return. So, a portfolio composed partly of stocks and partly of bonds is likely to have an even lower return than the 3.7% noted earlier.
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Expected Return on Investment per Asset Class
What is an investor to do? There are really only a couple of choices. First, you can save more and for longer. This is probably the safest of the options. As discussed on the future value function post, we see that if you decrease the rate of return, you must increase either the amount added to the portfolio each year or the number of years the portfolio has to compound that return if you hope to arrive at the same place. Second, you can take on more investment risk. There are riskier asset classes than the overall US stock market. In general with investing, higher risk carries the possibility of higher returns. Asset classes such as small stocks, value stocks, and emerging market stocks have higher expected returns than the overall market.
Rick Ferri, in his excellent book, All About Asset Allocation (2006), lists the following expected returns for various asset classes:
While many would quibble about the actual values in this chart and the wisdom of investing in many of the asset classes listed, the point is clear. If you have a portfolio with a large number of small stocks, value stocks, and riskier international stocks, your expected return (and risk of temporary and permanent loss) is higher than that of one who holds only a US total stock market fund. Also, the lower the percentage of bonds you hold in the portfolio, the higher the expected return.
Naturally, a portfolio composed entirely of emerging market stocks brings its own problems, and it is NOT recommended. Lastly, an investor can hope that “alpha” can be added to their returns. This is the additional return possible from superior security selection and market timing. The number can be positive OR negative, depending on the skill of the manager, and, for all investors as a whole, it's zero before expenses (and well below zero afterward). Unfortunately, the data show that this skill is quite rare, and it probably shouldn't be counted on to add significantly to returns.
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The Bottom Line
To many of you, the expected returns I've discussed above seem quite low. I know how disappointing that can be. But hope isn't much of an investment strategy. Given how low future expected returns could be, it is all the more important that the wise investor reduces the bite of taxes and investment expenses on the portfolio returns.
The bottom line? Have a realistic view of what you can expect from investing over the long term. If you do not, your investment plan will likely result in failure due to your own behavior. Even though 2023 and 2024 returned more than 20% from the stock market, keep in mind that when estimating future returns for your portfolio, use after-inflation, after-tax, after-expense returns that are realistic—such as 2%-6%.
How do you expect the stock market to perform over the next few years? Are you more optimistic than the numbers in this post show? How is it going to affect your investment plan?
[This updated post was originally published in 2011.]
This is a good article.
I think one of the more important things for an investor to realize is that when market returns are poor, then the wealth creation has not vanished – it has been deferred. Poor current returns increase expected future returns, and the reverse is also true – high current returns decrease expected future returns.
The speculative component dominates market returns over any short period (ie 5 years!) but is less relevant over long periods. It is actually easier to predict long-term market returns than short-term returns.
I also want to note that current dividend yields look much worse than they really are, since modern companies have shifted much of their cash distribution to buybacks. Many major companies such as Walmart and Coke have yields of 2-3%, but if you add in the cash spent on buybacks (which they could just as easily have spent on dividends) their yields are more like 4-5%, bringing them in-line with historical payouts.
Good point on the buy backs, but I think a lot of that is cancelled out by giving options to executives, then just buying those same shares back! It would be interesting to see that quantified.
How is this projection holding up four years later?:
“Real returns for common asset classes over the next 7 years will be anywhere from -2% to 4%.”
It’s kind of interesting reading this back in the day before the huge stock growth. Now it’s not uncommon for many, even middle risk mutual funds to return 12% or more. FBIOX, for example, from Fidelity, returned an average of over 20% in the last 10 years with a 7/10 risk factor (middle-high)
Looking at this comment 5 years later hammers home this article’s point and Dr. Dahle’s investment strategy of broad market funds. This fund is -16% since you posted this 5 years ago..
Nothing like a little time to provide perspective.
Wow, this post did not age well. Nor did Jeremy Grantham’s estimates. Missed it by THAT much!
Should be a caution flag of how much confidence to put in such baseless projections. But of course, it likely won’t be.
I would love to read an updated version of this post given the pandemic. Dr. Dahle, do you think we can still expect these sort of returns moving forward?
Over what time period?
The longer the time period, the more “normal” I would expect returns to be. But obviously after a big run-up, you expect returns to be lower for a while. 1990s very good. 2000s not so good. 2010s good. 2020s probably not so good.
But my crystal ball is pretty cloudy as always.
Seconding the request for an update, particularly given inflation and the huge interest rate hikes. I have to imagine that the real return on Treasury Bills has changed some (but maybe not, since I’m bad at math!)
What do you want updated exactly? The sources to which the article links? Vanguard, Rick Ferri, and others tend to throw these things out every year. As you can tell, they’re not exactly prognostic of coming returns, especially in the short term.
Saw this article pop up in my e-mail today, and realized it was an update on an older article.
I think folks may disagree on some of the estimations as market returns have been quite different from the estimations.
But I think the point trying to be made here is that yes while the average return on say US stocks have been 10% over last 100 years, if you factor in inflation/taxes it’s more like 6% (think of your salary vs what you actually get to keep into your pocket). And most likely lower if you include bonds, and the fact that the 2010-20s returns have been above the norm. So plan accordingly with regard to your finances/retirement savings, is that right Dr. Dahle?
People disagreed with those estimates when they first came out too. Predicting the future is challenging.
Yes, when making plans about the future, you should use as realistic of numbers, and a range of them, as you can.
I started following WCI in 2021 after I finished my boards. Initially I used 5% real in my spreadsheet basically because “well that’s what Dr. Dahle uses” and “long term US average, minus 2%” seemed reasonably conservative. But I know at least Bill Bernstein and many others can’t see the numbers adding up to anything above a 4% real return based on div yield + earnings growth. Intuitively, that feels small to me for the risks one takes in the market, but it’s hard to argue with the fundamentals; money underlying stock valuations has to materialize at some point, I would think.
I switched my projections to 4% real, and to meet my goals it required an extra ~$2000 a month compared to 5% real (per Excel). Maybe that’s overly conservative, especially when I have pretty healthy amounts of domestic SV and international stock, but I’d rather show up to retirement unexpectedly wealthy than the contrary.
One thing I wonder is if this has implications for the so-called “4% rule.” If the Trinity study was based on a time period where the US market was churning put 7% real, if we can expect barely half that in the decades ahead, should the next generation be planning on a 3% rule or something?
Saving more does wonders and that’s what you do if you’re using lower numbers in your projections.
Bear in mind what the 4% rule comes from–the worst periods of time for which we have historical data. So to use much less than 4%, you have to believe that your SORR will be worse than has ever shown up so far.
Mhmm, that’s a fair point. As always, appreciate the perspectives from your posts.
Hey Jim, nice update on a classic article. I think the great recession in 2008 really explains why US equity expected return predictions were so low. When Ric Ferri made that chart in 2006 US equity valuations had recovered from the tech wreck. I would think that what you initially pay for your investments would have a huge role in your expected return. I remember when reading Bogle’s book thinking the speculative “return” could at times turn into a speculative “discount”. Maybe when you update this article again you can include what expected returns were at the depths of the financial crisis. Do you think this article is more prescient now given valuations are similar to when Ric made his chart in 2006?
I think the article is always useful, but valuations do affect some long term returns, they’re just really hard to use for any sort of investment moves.
Another very interesting article with links to previous good articles. Thanks!
I have a question about rental real estate. I have a couple of houses that are paid off and have appreciated.
I have been asked on occasion what my rate of return on these are. Is this a sensible question?
I know what my yearly intake (NOI) is from my schedule E for taxes, but what do I use for the denominator? My original down payment and closing costs for the mortgage?
Separately, would I take into account appreciation on the values of the properties? Or is that even logical?
Thanks in advance.
If you want an annual return (IRR) you need the value at the start of the year, the value at the end of the year, the cash flows and dates of money that went into the investment during the year and the cash flows and dates of money that came out of the investment during the year.
https://www.whitecoatinvestor.com/how-to-calculate-your-return-the-excel-xirr-function/
If you use the down payment and closing costs as denominator and the cash flows you took out of it this year, that would be a “cash on cash” return.
I think future returns will be higher. The most important factor is the rate of innovation, which is accelerating. Lots of companies currently in the S&P 500 didn’t exist all the long ago. Same will likely be true in a few decades. AI, robotics space, fusion, or stuff we can’t currently imagine will revolutionize our economy yet again. That’s why the current state of companies in the S&P 500 is not particularly useful for long term predictions.
Having said that, best to contribute in more to investments and maintains skills/prevent burnout so have the option of a long productive career, just in case.
Do you have a reference or citation for your prediction of higher returns? I forget which Bill Bernstein book it is, but he referenced that as empires age, valuations increase while (and ipso facto) returns tend to compress. Arguably, the Roman, Ottoman, and British Empires all experienced this phenomenon despite innovations and discovery filling all three cultures.
When you buy international stocks do you hedge the currency exposure?
I don’t. I don’t know anyone who does. Do you?
I don’t. I think I would if I could do so costlessly but the currency hedged international equity etfs were at least 35 bps above just buying vxus.
Not hedging also provides a bit of bonus return when the dollar weakens. I suspect that may provide more benefit to the overall portfolio by reducing correlation between US and international stocks.
Does this mean that someone should prioritize paying off a 5+% mortgage as early as possible, rather than putting more into savings?
Depends on your goals. But paying off a 5% mortgage provides a 5% return, at least before any tax considerations/adjustment.