If you invest money, perhaps because you want to give money in the future, you want a good estimate of the real rate of return so you can compare it to just giving now. Small differences in this estimate have very large effects over decades, and just today I've seen people giving numbers as far apart as 2% and 8%, which over 40 years mean 2.2x growth and 22x growth respectively.

What is reasonable here? If you look around online at personal finance sites you'll see numbers like 6%, 7%, 10%, 11%, and even 12%. First off, these all ignore inflation, which has averaged about 3%. Naively subtracting, this gives us real rates of 3%, 4%, 7%, and 9%. There's also a lot of cherry-picking: if you're willing to choose specific years and specific indexes you can get quite good numbers.

There's an even bigger cherry-picking problem, however, in that they're all based on US returns. Other countries have had worse economic performance, or have even had their stock markets wiped out. Dimson, Marsh, and Staunton (2013) (pdf) (summary) conclude that investors should expect much lower returns:

We have estimated that over the next 20-30 years, global investors, paying low levels of witholding tax and management fees, can expect to earn an annualized real return of no more than 3.5% on an all-equity fund and 2% on a fund split equally between equities and government bonds.

The difference between 7% interest and 3.5% interest is the difference between 60x and 8x over 60 years. This is really important if you're trying to decide whether you do better to save money now and donate later after several decades of compound interest. [1]

[1] If you're saving for your own retirement tax incentives are probably more important than interest rates.

Cross-posted from my blog

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22 comments, sorted by Click to highlight new comments since: Today at 7:16 PM

There are also those that argue that even these expectations of return are based on an extremely atypical era of history in which rapid industrialization of much of the world lead to being able to expect a return due to rapid expansion of the real economy, and that the US was uniquely poised to take advantage of this era because (among other things) we were one of the few industrial nations that was not bombed extensively during WWII. That era could be ending, with a saturation of bankable projects with high returns to large populations and rapid slowing (and in some cases reversal) of expansion of resource extraction and population growth and the pulling of existing population into market systems. This is far more global than the previous disruptions talked about in this analysis.

If this is the case, we can expect long-term real returns to become far lower on average than even these estimates, far more unpredictable and volatile, and very difficult to weed out from the much higher short-term unstable returns of ponzi finance that creates high notional wealth without a corresponding investment in the real economy to stablize it.

Surely if a certain future payoff is expected a priori to be good (because of expected favorable business climate or whatever), then the price paid will adjust accordingly. This means that expected return (a function of price paid and payoff) will be comparable to other investments with similar payoffs, rather than being good.

If, say, business climate were unfavorable, and payoff is expected to be low, price paid for the investment should adjust for this so that expected return need not be low.

If there is large degree of uncertainty associated with a payoff, then expected return may be high to reflect the low price one might get due to people's distaste for variance. (The expected return may be low though if people have a taste for variance; e.g. lottery tickets.)

The point is that expected good economic conditions per se need not be the driver of a priori expected returns. (That they are expected means that the price adjusts to reflect this, leading to mediocre returns.) Rather, the higher order moments of the (subjective) payoff probability distribution may play a more important role.

Could you spell out what you mean? or point to someone who claims to believe this in more detail?

What much of the world was industrializing after the war? What percentage of publicly traded firms exploit foreign investment opportunities?

The German stock market did a lot better than the US market in the 50s.

later: it would make more sense to talk about reconstructing Europe and Japan than about industrializing new places, but my other comments continue to stand: why would US equities be a good way to invest in Germany, and why would does the US return beat the European returns, when Europe captured most of the value of its reconstruction?

If you're saving for your own retirement, you might want to consider the risk of dying before you can spend that money. A 25-year old male has an 18.6% chance of dying before he reaches 65, so he should discount his expected return accordingly.

If you're saving for your own retirement, you might want to consider the risk of dying before you can spend that money. A 25-year old male has an 18.6% chance of dying before he reaches 65, so he should discount his expected return accordingly.

Note that the discount is in the direction of how much you value the assets in your estate after death. ie. Altruistic (and nepotistic) preferences still apply so do not simply multiply by (1-0.186).

Not just the risk of dying; consider also the risk of some world event that makes your savings irrelevant, like a Singularity or a global economic crash.

Or, on a much smaller scale, the risk of switching jobs. My employer match doesn't vest until I've been on staff three years; the numbers for maxing it out look very different if I want to look for a better position elsewhere before then.

If you're referring to a 401k, it's worth maxing it even without the employer match, because the tax incentives are so large.

You also have to figure out the effective rate of return on your charitable giving, if any, right?

Antti Ilmanen's "Expected Returns" is probably one of the best attempts to answer these questions. This book is however quite pricy.

From the intro: "Finance theories have changed dramatically over the past 30 years away from the restrictive theories of the single-factor CAPM, efficient markets, and constant expected returns. Current academic views are more diverse, less tidy, and more realistic. Expected returns are now commonly seen as driven by multiple factors. Some determinants are rational (risk and liquidity premia), others irrational (psychological biases such as extrapolation and overconfidence)."

It is worth mentioning that he has another book "Expected Returns on Major Asset Classes" that is a shorter version covering the central chapters of the pricy book. The kindle version is inexpensive.

I don't think it's useful to discuss rates of return without discussing Risk. Risk and rate of return are inseparable.

If you need to put money someplace and have at least that much available, (plus interest) in one year, you will get a low level of return (US Fed back CD's are at 1% nominal). You do run a slight risk that the bank will default and the FDIC will default on its obligation to back its promises, but that risk is (IMHO) very very small.

If you want to try to make 25% return in a year, you can do some e things (become a loanshark seems like a picturesque example), but you run a risk of losing all or some of your money and/ or expected return (due to ignorance of the business, possibly).

Generally you hear that investing for long term gets higher returns, but really it's being flexible about when you want to "cash out". The longer the investment the greater your ability to be flexible. If we're talking about investing for 60 years, and you'll withdraw the money on April 7, 2073, you won't be as successful that if you're investing for 60 years plus or minus 10 years.

Oh, and "Investment" is a very broad term. "Securities" may be more appropriate to your meaning. And a discussion of investment risk should include the possibility that we're living in a century long industrial revolution investment bubble.

Are you saying that you should look at the probability distribution of returns, rather than only the mean of that distribution? A 1.00 chance of a 1.0%-inflation real return is significantly different from a coin flip with 0.50 chance of losing everything and 0.50 chance of 102%-inflation real return, even though their expected values are equal.

Perhaps we should instead assign a utility function to rate of return; it's entirely reasonable that the utility difference between a 500% return and a 600% return is much smaller than the difference between losing everything and keeping what you have.

There's an even bigger cherry-picking problem, however, in that they're all based on US returns.

That doesn't seem like it's that big. While there are about 196 countries, most of them are much smaller and less well-developed than the US, and the US was most likely chosen for this reason. It's not simply the luckiest country.

On the other hand, if the US had better returns based on something other than luck, you'd expect people would keep investing there until the returns drop.

The US is unusually large and developed precisely because it has had abnormally high growth (and also, therefore, high immigration).

It's due to a combination of being old and having sustained abnormally high growth. If it's sustained, then it's not just luck. You can invest in the US and know that it will continue growing like it did before. It's not cherry-picking.

If it's sustained, then it's not just luck.

Kinda the point of survivorship bias and other selection effects is that you can get what looked like 'sustained' performance just by luck...

Said many people in every bubble ever.