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Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today I'm talking about how to earn a healthy 7% rate of return on your money in this difficult environment. The average interest rate for savings accounts is 0.06%. National home prices just reported their highest one-year gain in history.
The US stock market is up almost 700% since March of 2009. And then you have things like cryptocurrency. Bitcoin is up over 7,000% in the last five years. When everything seems risky and overbought, how do retirement savers invest their money if they're hoping to earn a healthy 7% to 8% rate of return on their investments over, let's say, the next 10 to 20 years?
I was recently asked this question by Stay Wealthy listener Robert G, and I thought I would expand on my answer here on the show so everyone could benefit. Before I do, as always, you can grab the links and resources for this episode by going to youstaywealthy.com forward slash 127.
So before I put some real numbers to all of this, one simple exercise to start thinking about the current environment and what it might take to earn a 7% rate of return is to rewind back to, let's call it the early 90s to the early 2000s before the financial crisis hit. You might remember that during that timeframe, cash in the bank was paying you anywhere from 3% to 6% depending on what interest rates were doing that year.
Let's keep it simple and say you were earning about 5% on your cash during that time period. Well, in that scenario, you didn't have to take much risk or look very far in order to stack on an additional 2% of return to achieve that healthy 7% rate of return on your total investment portfolio. You could keep most of it in cash and treasuries and sprinkling a few blue chip stocks and you're there.
When cash, a riskless asset, is paying 5%, earning 7% to even 10% rates of return feel pretty easy and attainable.
But when cash is paying nothing, you have to take an immense amount of risk in order to go out and get a 7% rate of return. Literally all of your return has to come from risky assets. And yes, it's been fairly easy up to this point. Over the last 10 years, you could have thrown a dart at pretty much any asset class and done pretty well.
But if we're being smart, prudent investors and thinking objectively about where we are today, right now, I think we can all agree that it's hard to expect things to continue to be this easy for the next 10 or more years, given some of the numbers that I shared at the top of the show. And to be clear, I'm not suggesting that the market is going to collapse and you should take all of your money out of stocks and put it under the mattress.
My goal with today's discussion is simply to set proper expectations around risk and return. So you're properly positioned and prepared for the next 10 plus years, which for most of you listening is being spent in retirement, a time when we need safety and preservation of capital.
but also a healthy rate of return so we don't outlive our money. If you listened to the retirement income series last month, you know how much a healthy rate of return means to maintaining your retirement paycheck.
The problem is American investors in particular are the most optimistic about future returns, expecting an average of 13.2% total annual returns over the next five years, according to the recent Schroeder Global Investor Study. Expectations are way out of whack with reality, which is a recipe for trouble.
Another way to frame the current environment and bring to life how much risk we are being forced to take is to actually go back in time to see what sort of asset allocation you actually needed to earn that healthy 7% rate of return compared to what might be needed today.
A quick note before I do that, to help quantify risk, I'm going to reference standard deviation. And all you need to know about the standard deviation of an investment for today's conversation is that if it's a high percentage, let's say 15 to 20%, it would be considered risky. And if the standard deviation is a low percentage, let's say below 10%, it's a less risky investment.
For example, an S&P 500 index fund like SPY, which is comprised of all U.S. stocks, has a 15-year standard deviation of about 17%. A safe U.S. Treasury index fund is closer to 3% or 4%.
So with that in mind, if we go back to 1995, we could have achieved a nominal return of seven and a half percent by putting 100% of our portfolio in bonds. And this is according to a study done by Callan Associates.
And the standard deviation of that bond index that was being used in 1995 was a mere 6%. In other words, you didn't have to take much risk at all to go out and snag seven and a half percent. You took about one third of the risk of the US stock market to do it. Now, fast forward to 2005 and things got a little bit trickier.
You needed 52% in bonds and 48% in a handful of different stock asset classes, including US stocks, international and REITs in order to get that same 7.5% rate of return. The portfolio as measured by Callan Associates as part of the study had a standard deviation of about 9%. So you had to reach for a little more risk in 2005 to get your respectable rate of return that you were looking for, but not much.
Then in 2015, things started to get really interesting. To get your 7.5% rate of return, you were looking at 12% in bonds and 88% in global stocks. And the standard deviation of that portfolio being measured in this study was 17%, which by most measures would be considered risky.
The article, which I'll link to in the show notes was written in 2016. And the first sentence sums up the environment at that time in four words by saying bigger gambles, lower returns. Now,
Now, you might be saying to yourself, well, the authors were completely wrong. The market kept on going up and I had no issues earning a healthy return over the last five years. Didn't feel like I had to take much risk at all. And you would be correct by saying that the S&P 500 is up about 140% since that article was written in 2016, which I'd argue means it's even more
more important to understand the risks that you're currently taking and the risk you'll likely need to take over the next 10 to 20 years to continue earning that healthy rate of return.
I think it was Meb Faber who recently summed it up well by saying, and I'm paraphrasing in my own words here, that the U.S. stock market can, of course, continue to go up and valuations continue can continue to go up into even higher extremes. Just know that if that happens, you're essentially pulling future returns.
into the present, that higher valuations simply mean lower future expected returns. Kind of like China, when their CAPE ratio, a popular valuation metric, got up to 50 or 60 in 2007 and then after that experienced a flat stock market for the next 10 years.
By the way, this works the other way around too. If the US stock market drops 30 to 40% and valuations come down, then you would expect higher future returns. Maybe not immediately, but over long periods of time, lower valuations would indicate
higher future returns. So again, yes, the broad U.S. stock market continue charging upwards. But remember that you're just pulling future returns into the present if that happens, which will lower future expected returns.
With all that information in our hands, what does one do to put themselves in the best possible position to continue earning a healthy rate of return in retirement without taking an unreasonable amount of risk and exposing themselves and their retirement plan to catastrophic losses?
To answer that question, we first have to revisit some of what I talked about in my retirement investing series from September of last year. And that is that the US stock market and all all stock markets has multiple layers, more layers than the news headlines might lead you to believe. The media often references the S&P 500, which is an index that tracks the largest 500 companies in the US.
They reference the S&P 500 to share how good or bad the current market is doing. If you own an S&P 500 index fund, it's important to know that the larger a company in that index gets, the more of an allocation you have to that company. In other words, you have a higher and higher allocation to companies that are getting larger and larger and becoming more and more successful.
which is quite the opposite from the old adage, buy low, sell high, or value-based investing where you aim to buy companies when they're cheap and hold them until they're expensive. You're literally doing the opposite in a plain vanilla S&P 500 index fund. The bigger a company gets, the more you buy and end up owning in your S&P 500 index fund.
The technical term for this is market cap weighting. S&P 500 index funds like Vanguard's VOO fund are weighted by market cap. So companies with larger market capitalization get a higher allocation. For example, the top 10 holdings in the Vanguard S&P 500 index fund make up 30% of the entire fund with names like Apple, Microsoft, and Google at the very top.
If you're a longtime listener, you know that I'm a huge fan of low-cost passive index fund investing, but I'm not a fan of market cap weighting, which is all too common. Weighting a portfolio instead based on valuation metrics, i.e. having a larger allocation to companies that are cheap or undervalued,
Profitability and size has historically helped to reduce risk and improve returns. Also, expanding your portfolio and investing overseas is a way to improve diversification and returns and also help mitigate risk.
Investing in developed international stocks and emerging markets currently have lower valuations than the U.S. market, i.e. higher expected future returns. While it's okay to have a home country bias, U.S. investors currently have about 80% of their stock allocations invested in U.S. stocks, which I'd argue is exposing them to more risk than they might be aware of.
Taking a more prudent academic approach to investing, avoiding putting all of your investments in market cap weighted index funds because they do have some benefits, so it's okay to hold some. And investing globally are ways to help combat this tricky environment and earn a healthy future rate of return.
To help illustrate how taking a more prudent approach might help you better earn a higher expected future return, let's quickly look at Vanguard's recently released return expectations for all the different asset classes. And I'll link to this in the show notes. So the 10-year annualized return projection for U.S. growth stocks, according to Vanguard, is negative half of a percent to one and a half percent per year.
However, the projection for U.S. value stocks is between 3.5% and 5.5% per year, and the projection for international stocks is 5.5% to 7.5% per year.
For what it's worth, most 10 year annualized bond projections from Vanguard are between 1% and 3% per year, depending on the credit quality of the bonds you might own. Remember, bonds are fairly easy to predict. The starting yield is a pretty good indicator of its future returns.
Now, these projections are about the future and nobody has a crystal ball, not even Vanguard. But it helps to illustrate how investors like you and me might begin thinking about where returns are going to come from in the next 10 or more years. So going back to where we started today's show.
What does it take to earn a 7% rate of return on average over the next 10 plus years? Well, according to Vanguard, it's going to take investing in 100% international stocks, which by their projection will carry a median standard deviation of about 19%. In other words, you'll have to take a lot of risk to get there.
Just for fun and the chance you find it helpful, other large financial institutions publish similar future return expectations, most of which, like Vanguard, are based on current valuation metrics, earnings growth and inflation expectations, not necessarily a crystal ball that they pretend to have.
Schwab is quite optimistic, expecting 6.6% annualized total returns for U.S. large cap stocks, still much lower than the long-term historical average of 10%, but much higher than Vanguard. They also expect 7.1% annualized returns for small cap U.S. stocks and 6.5% for international returns.
JP Morgan is expecting 4% returns from U.S. stocks, 5% to 6% from international, and 7% from emerging markets. And Morningstar is the least optimistic, expecting a negative 0.1% from U.S. stocks annually on average for the next 10 to 15 years, and about 4.5% from international stocks.
While all these research arms and financial institutions have slightly different expectations, the one common conclusion is that international stocks appear to be the most undervalued and therefore have the highest future returns or future expected returns.
Small cap stocks and value stocks, while not specifically named by each of these companies, also have lower current valuations by a lot of the different metrics. And therefore, one could argue also have higher future expected returns versus your broad based index funds that are market cap weighted or large cap U.S. growth stocks, which have done very, very well in recent time periods.
There are three big takeaways that I want to end with here. Number one is it's going to take a lot more risk today than it did in 1995 or even 2005 in order to achieve an, an a healthy average annual 7% rate of return going forward.
Number two, if the broad market indexes continue to charge upwards with little volatility, which could very well happen, just know that we are pulling future returns into the present and it will just make it that much trickier to expect healthy, consistent returns going forward from there.
And then number three, the market is not the S&P 500 or the Dow Jones Industrial Average. When you hear someone say that the market is overvalued, ask them which market, because there are countries, asset classes, sectors and individual companies that by most measures appear to be undervalued or even just less overbought than these broad market indexes.
Diversification and prudent, evidence-based academic approaches to investing have never been more important than they are today. For all the links and resources mentioned, head over to youstaywealthy.com forward slash 127. Thank you as always for listening, and I will see you back here next week. This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.