I recently received the following reader question:
In “Appreciating Assets Part 1: Stocks and Bonds,” you wrote, “On average, equity investments appreciate at a rate of 6.5% over inflation.”
Can you please let me know on what study this is based? As I read the historic equity risk premium is about 4.6%, substantially lower, and this would have a huge impact on your draw down rates.
There is a difference between “equity risk premium” and “real return over inflation.”
The historical equity risk premium is the return of equities minus the so-called risk free rate of return. The proxy most often selected for the return of a risk-free, guaranteed investment is the current return of the 3-Month (90 or 91 day) Treasury Bill.
I did a review of the 3 Month Treasury Bill and the S&P 500 Composite Total Return between 12/31/1979 and 12/31/2018 and found that the average annual rates were 4.31% and 11.35% respectively which is a risk premium of 6.75%.
I noticed that some bloggers were suggesting that the ten-year treasuries be used for the risk-free rate of return. However, this suggestion is not correct. Ten-year treasuries have significant interest rate risk. Using that risk-free rate would both not be accurate and significantly reduce the equity risk premium.
In contrast, the real return over inflation is the return of equities minus the inflation. The Consumer Price Index is the official measure of inflation.
I did a review of the Consumer Price Index and the S&P 500 Composite Total Return over the same time period, between 12/31/1979 and 12/31/2018, and found that the average annual rates were 3.10% and 11.35% which is a real return of 8.00%.
The data for the Consumer Price Index goes back further than the 3 Month Treasury Bill. When I take the analysis back further and include the near hyper-inflation of the 1970s, then I receive a different result for the real return of the markets.
Using data between 12/31/1969 and 12/31/2018, which is ten more years than used before, the average annual rates for the Consumer Price Index and the S&P 500 Composite Total Return were 3.95% and 10.21% which is a real return of 6.02%. This is because inflation-adjusted returns were extremely poor during the 1970s. That decade had some of the worst inflation-adjusted returns and was used to set Bengen’s 4% rule. This period of time is also used in Monte Carlo to test withdrawal rates.
The real return of the stock market is often debated. Using the S&P 500 Composite Total Return gives one answer while including returns from mid- and small-cap produces a higher return. Those who include countries that are low in economic freedom will calculate a lower return. But we believe that somewhere around 6.5% is a reasonable number. Here are examples of others who suggest a real return of 6.6% and 7.0%. While these are long term averages, stock market returns vary widely and even a decade is not long enough to experience the average return.
Regarding draw down rates, or as we call them “safe withdrawal rates“, limits are usually based on the worst possible markets and 30-year time periods averaging returns of only about 3% over inflation or less. Using Monte Carlo techniques, a success rate of 85% is acceptable. This means that 15% of the time you may have to reduce your inflation-adjusted lifestyle downward, while 85% of the time you may be able to adjust your lifestyle upward.
Some bloggers write about what they expect the risk premium or inflation-adjusted return to be in the near future. Dire warnings about the stock market always receive the greatest online attention. However, such near-term forecasting is a wild guess at best, even when metrics are used to justify it.
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