Assumptions for Long Term Rates of Return

DJIA 30-Year Rate of Return

This graph shows the rolling 30-year rate of return for the DJIA around December 12th of each year from 1958 (i.e. from 1928-1958) to 2011 (i.e. from 1981-2011)

When I first started in this business, the common rate of return for a long term investment that I would hear touted  was 8% and sometimes as high as 10%. I recently decided to have some fun and check out what the investment return was for a number of periods looking at the DJIA. I gathered this information from the Dow Jones Industrial Active Learning Center under the Resource Center tab. Now, before the cries come out regarding using the DJIA, let me acknowledge some of the issues that I am sure that people will have:

  •  Looking at the DJIA does not reflect a balanced portfolio since it relates to very large cap if not mega-cap companies.
  • There are several allocations and investment strategies which long term have had better performance than the DJIA.

These issues do not counter the one problem that is aptly illustrated in the graph above. Averages, even 30-year averages, change over time. I will assume that you may have come to realize that just because you have an average return of X, that it is not to say you will have a return of X every year. In fact the average will change each year as the numbers change. And this is well and good as long as things remain relatively the same. But what if they are different?

If you were to take the average of the DJIA 30 year average for the past 20 years, you would get something close to 8%, with numbers of 30 year returns ranging anywhere from 4.7% to 10.1%.But what if you were to include 30 year averages from beginning in 1958 until now? You then have a range of numbers from 2.45% to 10.1% with an average return of 6.36%. If we were to look at the “average 30-year return for the DJIA” not including the past twenty years, we would have a return of 5.43% with a range of 2.45% to 8.18%.

Given these numbers, is it truly fair to assume an 8% rate of return?

Could it be that if anything, we have experienced a “golden age” when it comes to investment return and that we are heading back to the usual? I am not certain. I do believe to only look at what have been relatively good times when it comes to investment returns as it relates to financial planning is somewhat similar to pretending that clients have the benefit of playing poker with a deck of cards stacked in their favor when they do not.

Financial planning software often provides a number of wonderful ways to test the probable success of a portfolio, including Monte Carlo testing. That being said, these wonderful opportunities to check how valid our retirement assumptions may be depends on us not using a stacked deck in our testing. My hope is that this quick glance into the DJIA returns will cause people to question the basic assumptions of any financial plan including what is a fair rate of return and understand that averages are not static.

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