QuestForAMillion.net

Obviously nobody knows where stock values are going. Looking back over history, it seems relatively easy to predict future returns based on past results. After all, the Dow Jones Industrial Average (including reinvested dividends), has returned a yearly average of about 10.8% per year since 1930. But, as all investors know, past returns are not indicative of future results. If the returns of the past hold true, we can expect the stock market to be higher in 78 years, having returned better than 10% per year over that time frame. But is the future going to be like the past? And do any of us really care what the market is in 78 years? I don’t plan on working (or living) for the next 78 years.

It’s relatively safe to say that, given enough time, future stock values should be higher than they are today. How much is enough time? Nobody knows. Are stocks likely to be worth more in 8 years than next week? Probably, but the Dow was at 10834 on November 9, 2000 - resulting in a loss in the stock market over the past 8 years. Investors in 2000 relying on a repeat of the past have lost money in the past 8 years.

If we look at rolling 30 year periods in the stock market stocks have never lost money. Thirty years also corresponds fairly well to a working lifetime for most Americans. So, given what’s happened in the past, we can be fairly certain that stock values will be higher in 30 years than they are today. In fact, if we look at stock market returns over 10 year periods we don’t see any losses. Holding stocks for 10 years has always resulted in a positive return, historically.

Fantastic, but are stocks likely to return the 10%+ annually that they have over the past eight decades? I, for one, don’t think so. Most so-called experts agree, counseling investors to use 8% as the expected annual return of stocks in the future. Is 8% accurate? It’s lower than what we’ve seen in the past. But none other than Warren Buffett thinks 8% is too high. In an article in Fortune in 1999, Buffett gave a lesson on how to estimate future stock market returns with a simple formula:

Expected real GDP Growth + Expected Inflation + Expected Dividend Yield

If we look at Buffett’s formula and compare that to actual values from history, stocks have actually underperformed the formula most of the time. And if we plug numbers from today into the formula we’re looking at 6.5% annual returns - before expenses and fees (and taxes).

It’s no secret U.S. GDP growth is flattening. The United States is moving from an industrial, manufacturing economy to a services-based economy. This makes measuring GDP more difficult and results in lower numbers. GDP is defined as the total market value of all final goods and services produced within a country. Putting a price on services in considerably more difficult than putting a price on goods.

It’s been said that consumer spending accounts for about 70% of the U.S. economy. Consumer spending has been on a downtrend of late, with retail predictions for the coming holiday season dismal. A decrease in consumer spending will equate to a decrease in GDP, since companies that produce products will see a decrease in the number of those products sold.

Another factor pointing toward lower future returns is the maturity of the U.S. economy. During the 1900’s the United States was an emerging market. The country wasn’t very old at the beginning of the 20th century and the industrial revolution was just getting going. New industries were coming online and for most of the 1900’s the economy went on a rapid expansion, sending stock values soaring. The last 20 years of the 20th century were especially dynamic, with U.S. stock markets in a generation-long bull market. With the U.S. moving into a more mature economy, growth prospects for the next century aren’t as great. Many of Europe’s oldest economy’s have experienced the same maturity cycle, with corresponding lower stock market returns.

So what can we expect for returns in the future and what do we do about it? Using Buffett’s formula above, it seems like 6% is about the best we can hope for. This is not much higher than the historical return on bonds, which is about 5.2% - with considerably less risk. With interest rates currently very low, bonds are likely to have higher yields, and higher returns, going forward. Benjamin Graham, the father of value investing, advocates a portfolio of 50% bonds and 50% stocks in his investing classic The Intelligent Investor. This seems like a solid plan for the future if stocks market returns aren’t destined to outpace bond returns.

Of course nobody knows what the future holds. With stocks badly beaten down in the current bear market, it’s quite possible that stock market returns in the next few years will be higher than 6%. It’s equally possible that returns will be flat or negative. For my part I plan to explore stocks with a solid history of dividend payments. Dividends have accounted for a large chunk of the gains seen in the stock market historically. Concentrating on maximizing dividends seems like a solid strategy that should pay off in any type of market. I also plan to learn more about bonds and I will likely follow Ben Graham’s asset allocation advice.