Why Knowing the “rate of Return” Is the Key to Retirement Planning
Do you remember that time when Seuss Orman said that we should take all the money we piss on coffee and put it in instead? You can take the $ 100 a month you spend on coffee, she said (screamed? I think she screamed), and you end up with a million dollars in retirement.
As many investment experts note, there is a big problem with her math: she bases her hypothetical investment on a 12% rate of return. And if you, too, use that 12% to plan for retirement, you may have skewed expectations about how much you need to save.
If you walk around the room of financial advisors and ask them about the average return – how much an investment will lose or gain over a given period – they can each give you a different answer anywhere from 4% to that high 12%. This is because there are several ways to calculate it.
As Alessandra Malito begins to break it down at MarketWatch, she writes that you could look at any nominal rate of return that does not include inflation, or a real rate of return that does include inflation. “Ignoring inflation can lead to a loss of purchasing power by thousands of dollars or more,” she writes. If you use a retirement calculator that doesn’t take inflation into account, you may end up with an overly negative view of your progress and make you worry that you are not saving enough.
Here’s another variable that distributes the rate of return across the entire map: it is not the same for all types of investments.
There is more than one rate of return
The stock market has a long-term average return of 10%. Adjust this for inflation and you get an average return of 7-8% per year. If you only invest in stocks, you can expect your investment to grow by that amount each year, taking into account the large market downturns and peaks.
But you probably don’t have a retirement account that’s filled with stocks only, do you? You probably have bonds because they are less risky. Therefore, it is not surprising that bond yields are significantly lower. The US bond market has an average yield of about 6%. Consider inflation, and this average rate of return is slightly lower.
Now, the math problem of determining how much you need to save has an additional part: you have to anticipate growth for two types of investments with two different rates of return. And these are just general categories. Depending on the types of stocks in your portfolio (big cap, mid cap, etc.) or bonds (short term or long term), these subcategories all have their own different rates of return.
This is why you get experts who give you seemingly random rates of return. There is no one figure to count on.
If you have a financial planner or consultant, that person should be able to break down your investments by type in order to give you an estimate of how your individual portfolio should grow over time.
If you don’t need a financial planner yet, most retirement savings calculators will show you what rate of return they are using. Bankrate , for example, uses a 7% pre-retirement yield and takes into account an inflation rate of 2.9%. Nerdwallet’s allows you to choose your own rate of return, but the default is 6% for a “conservative estimate”.
And as we said, these retirement calculators can be intimidating. Even if they say you can retire in 6,000 years based on your monthly investment, that shouldn’t deter you from investing in general. Save what you can now. And while it helps you find out what factors affect the long term, don’t dwell on them too much.