Benchmarks, or rules of thumb, can be helpful in financial planning because they give an idea of whether you’re on the right track. They are useful for making quick approximations and estimations but may not always account for critical variables. Whether the 10% rule of thumb is a good benchmark for your own portfolio depends on a variety of factors, including your risk tolerance, time horizon, and more.
What Is the Rule of Thumb About Average Stock Market Returns?
The average stock market return over nearly a century has been 10%. As a result, investors often use this as a rule of thumb to determine what their own investments might amount to in the future or how much they need to save to reach an investment goal.
Where Does This Rule of Thumb Come From?
The 10% rule of thumb reflects the average annual historical return of the stock market, which is typically measured by the performance of the S&P 500 index. This index tracks the performance of 500 of the largest companies in the United States across 11 sectors and represents the health of the market as a whole. Since the S&P 500 wasn’t introduced until 1957, the Standard and Poor’s 90 index was used prior to that.
How to Use the Average Stock Market Return
Since the 10% rule is based on decades of data, it includes many years when the stock market returned less than 10% (as well as many when it returned more). That’s why it should only be used for long-term planning purposes like saving for retirement or your child’s education. With it, you can project how much an initial and subsequent investments might amount to, as well as how much you need to save on an annual basis to accumulate a target amount. For example, if your goal is to have $1 million available for retirement in 30 years and you use this rule of thumb to estimate your average annual return, you can calculate how much you need to invest in stocks to reach that goal. In this case, at a 10% annual rate of return, you’d need to invest $507 each month. Interestingly, if you started doing that 10 years earlier, you’d need to put away only $189 each month ($2,268 each year) to reach your goal. Not only does this illustrate the utility of the 10% rule, but even more so how important it is to start saving when you’re young to take advantage of compound interest. But several factors can affect your return. Perhaps the most important is your choice of investments, which will be influenced by your time horizon and risk tolerance. Management fees, expenses, and taxes will also affect your average return, while inflation will reduce your buying power and thereby reduce your effective return.
Time Horizon
The 10% average annual stock market return is based on several decades of data, so if you’re planning for a retirement that will happen in 20 to 30 years, it’s a reasonable starting point. However, it’s also based on the market performance of a 100% equity portfolio. In other words, if you’re hoping for a similar return on your portfolio, you’ll improve your chances by being entirely invested in stocks. But if your time horizon is much shorter—say, you’re retiring in the next five years—you should adjust your expectations (and the asset allocation of your portfolio). This is because short-term stock market returns rarely match up with long-term averages. In 2008, for example, the S&P 500 dropped 39% due to the financial crisis. The next year, it was up 30%. In fact, had you been invested in the S&P 500 for five years from the beginning of 2004 through 2008, your portfolio would have lost an annualized 2.26% (each year). If you’d been in for the five years ending in 2009, you would have only gained 0.55% on average each year. This is why the 10% rule of thumb doesn’t work for shorter time horizons. If you won’t be invested long term, it’s best to choose investments that are less volatile (less prone to wide market swings) and more conservative to help ensure they’ll be there when you need them, which usually means lower long-term returns. Drew Kavanaugh, a CFP and vice president of wealth advisory firm Odyssey Group Wealth, gave an example: “New parents can take on more risk early in their children’s lives when saving for college,” he said. “But as the tuition bill comes closer, they want to make sure their savings aren’t as susceptible to wild market fluctuations.”
Risk Tolerance
While how long you’ll be invested affects your portfolio’s asset allocation, so too does your risk tolerance, or how well you can handle large gains and losses. This is because realizing long-term gains depends on staying in the market, through the ups and downs, long term; in other words, not overreacting and selling when you’re losing money and then trying to time when to get back in. The higher your tolerance for risk, the easier it will be for you to endure wide market swings and resist the urge to sell. However, if you have less of a stomach for risk, such that big losses could keep you up at night or inspire you to liquidate your holdings, a more conservative portfolio allocation makes more sense—meaning one that is ideally safer and designed not to experience major losses (or gains). This can be accomplished by adding fixed-income investments to your portfolio, such as bonds and bond funds, CDs, and money market funds. But if you add fixed-income investments to your portfolio, you need to adjust your expectations downward regarding anticipated returns. For example, a “balanced” portfolio that’s 50% stocks and 50% fixed income has had an average annual return of 8.3% since 1926.
Taxes
Depending on the type of account you have, as well as how long you hold individual investments, taxes can reduce the value of your return. If you have a taxable brokerage account, you will pay ordinary income tax rates on gains from investments you hold for less than a year—these are called short-term capital gains. But for investments held longer than a year, you’ll pay a lower long-term capital gains tax rate when you sell—between 0% and 20%, depending on your tax bracket. For example, suppose you made $100 selling a stock you bought for $1,000 and held less than a year. If you’re in the 22% income tax bracket, you could pay $22 on the short-term gain, thereby reducing your net gain to $78 and your net return on that stock from 10% to 7.8% for that year. If instead the gain was long term (you sold after one year), you’d pay $15 if your long-term capital gains rate is 15%, reducing your net return to 8.5%. This is why it’s best to use tax-advantaged accounts, such as IRAs and/or a work retirement plan like a 401(k), if you’re saving for a long-term goal like retirement. Within these accounts, gains aren’t taxed, which allows those gains to compound and experience “tax-free” returns that can better approximate the rule-of-thumb return of 10%.
Fees
If you’re paying someone to manage your portfolio, just like taxes, the fees you pay also reduce your return. Management fees vary depending on the type of services you need and the firm you use. But even if you manage your own portfolio, you’re probably paying mutual fund expense ratios, which are fees mutual funds charge for fund management and administration, marketing, and distribution. In 2019, the average mutual fund expense ratio was 0.45%. To give you an idea of how even small fees can diminish your expected return, let’s consider a $10,000 mutual fund investment in a tax-advantaged retirement account. We’ll assume that the fund’s expense ratio is 0.45% and your average annual market return is 10%. After 30 years, the investment would grow to $154,302. However, if the fund is, say, an ETF with an expense ratio of 0.10%, the same investment after 30 years would be worth $169,797—that’s $15,495 more.
Grain of Salt
Even if you invest in 100% equities in a tax-deferred account for at least 10 years and hold investments with very low fees, your results still may differ from the 10% benchmark return. Why? There are a few reasons.
Various Market Sectors and Stocks Have Different Returns
For example, the 10-year average annualized returns for the S&P 500 Consumer Discretionary Index and S&P 500 Energy Index are 17.02% and –1.67%, respectively.
Market Timing Affects Your Return
Your return depends on when you get into a stock or fund and how long you’re invested for. For example, let’s say you’re an aggressive investor with a high tolerance for risk. You decide to invest in a fund that tracks the MSCI Emerging Markets Index, which holds 27 large and midcap companies across 27 “emerging market” countries. If the fund you’re in mirrors it exactly and you got into it in 2009, you would have seen an average annual return of 12.35% through 2020 (not accounting for management fees). But instead, suppose you got in two years later, in 2011. Then your average annual return would have been less than half as much, at 5.07%.
Inflation Eats Into the Value of Your Return
Inflation will affect the buying power of your earnings. Over time, what you can buy with a dollar is typically less than what it is today. For example, if you adjust a 10% stock market return for an inflation rate of 3%, the real rate of return is actually 7%.
Uncertainty May Drive More Conservative Investment Decisions
Also, it’s important to remember the old adage that past performance does not guarantee future results. Because of this, financial advisors may use more conservative assumptions during the planning process. “If we overestimate market returns and underestimate living expense or inflation, it could dramatically affect the life of the client,” Kavanaugh said. “I don’t want to be the one to tell a client they are going to need to get a job in retirement because our estimates were too rosy.” The conservative approach may require higher contributions, but it can prevent shortfalls if the market doesn’t live up to its past returns.
