These days, a lot of people are asking themselves this very question. For most, including myself, I have a unsatisfying answer:
We don’t save enough money.
Think about it. If I had a billion dollars and my current lifestyle, I could simply build myself a Scrooge McDuck vault and just spend it gradually. No banks, no stocks, no bonds.
But I don’t. I have to try and fund both our ongoing and future expenses with our income. In order to make this more likely, I need higher returns. Unfortunately, this sometimes means investing in things that are riskier. Things that can drop 45% in less than a year!
What kind of after-inflation returns can I expect from stocks?
I explored the sources of long-term stock returns here. But as correctly pointed out they are nominal (before-inflation) returns . What about real (after-inflation) returns? Isn’t that what really matters?
Here is the adjusted equation:
Historically, the real earnings growth has been estimated at around 2%. At current depressed prices, the dividend yield of the US Stock Market as a whole is about 3%. Thus, this suggests that we can expect 5% real returns before expenses.
But don’t take my word for it, take it straight from Warren Buffett, in this semi-famous 1999 Fortune magazine article:
Let me summarize what I’ve been saying about the stock market: I think it’s very hard to come up with a persuasive case that equities will over the next 17 years perform anything like–anything like–they’ve performed in the past 17. If I had to pick the most probable return, from appreciation and dividends combined, that investors in aggregate–repeat, aggregate–would earn in a world of constant interest rates, 2% inflation, and those ever hurtful frictional costs, it would be 6%. If you strip out the inflation component from this nominal return (which you would need to do however inflation fluctuates), that’s 4% in real terms. And if 4% is wrong, I believe that the percentage is just as likely to be less as more.
4% real return, which was after taking out 1% in assumed management fees and commissions, again brings us back to 5% after-inflation returns from stocks. In exchange, we get a lot of volatility – big dips and peaks, and the dips can last a long time.
What if we wanted to take minimal risk?
I am nearly done with reading a book by economist Laurence Kotlikoff and financial advisor/columnist Scott Burns called Spend ‘Til the End: The Revolutionary Guide to Raising Your Living Standard–Today and When You Retire. In it, instead of recommending a portfolio of mostly stocks and adjusting from there, they start from the other direction. They believe you should start with a portfolio consisting entirely of inflation-protected bonds and see if you need more return from there.
Treasury Inflation-Protected Securities (TIPS) are bonds issued and backed by the U.S. government that promises you a total return that adjusts with inflation. Very generally, it works like this: if the stated real yield is 2% and inflation ends up at 4%, your interest payment would be 6%.
Coincidentally, the last few weeks have given us a huge surge in the real yield offered by TIPS, around 3%. This is the highest it has been in many years:
If you had enough money, such that a fixed 3% after-inflation return is adequate for your needs, then you wouldn’t have to take on very much risk. You wouldn’t have to own any stocks at all. Of course the market value of these bonds will still vary along the way, but if you hold until maturity you will get the real yield. And it is guaranteed by the government, just as much as “regular” Treasury bonds.
If you invested $5,000 inflation-adjusted dollars every year for 30 years, with a 3% return you would end up with $257,000 in today’s dollars. If you invested the same amount at 5% you would have $370,000 – 44% more.
Of course, 100% stocks or 100% TIPS are at two extremes. But as you can see, either saving more (or living on less in retirement) allows us the luxury of needing to take less risk. Which means in times like these you’d be much less stressed. The question is, can we save enough money to pull this off? I don’t know, but I think I may try harder now.