# Will Future Long-Term Stock Returns Be Less Than 8%?

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While reading The Little Book of Common Sense Investing by Vanguard founder Jack Bogle, I found one of the chapters on predicting future stock returns especially interesting. Here’s my attempt at summarizing it.

What are we buying when we buy a share of a company? Essentially, we are buying a stream of future money. That money is returned to us the form of earnings growth (which increases the share price) and dividends (which goes straight to us as cash).

As an example, let’s take a fictional company and call it Bob’s Taco Shack. The taco stand has earnings of \$20,000 a year. It has 1,000 shares, so it’s earning \$20 per share (EPS). Bob gives out \$10 of that \$20 as a dividend to shareholders, and reinvests the remaining \$10 back into the company. Currently, the share price is \$200, which gives us a price/earnings ratio of 10 and a dividend yield of 5%. Now, let me pose some statements, which I hope make sense.

1. If earnings stay constant, then one would expect the share price to stay constant as well. The stream of money coming is the same, so the price should be the same.
2. If earnings stay constant, and dividends are 5% year, then your return should be just that 5% a year. From the example, you just get that \$10 in dividends (5% of \$200).
3. If earnings grow by 5% a year, and there are no dividends, then your return would again be 5% a year. You are paying 10 times earnings. If the earnings go up by 5% to \$21 per share, then the share price should go up to \$210. You earned the same amount as the earnings grew.

This leads to the formula for what Bogle terms the “fundamental” return:

## Fundamental Return = Earnings Growth + Dividend Yield

Now, if Bob announces that he plans to expand into fancy shrimp tacos and fish tacos, then maybe people will expect higher future profits and be willing to pay more per share, raising the P/E ratio. But this is based on speculation. Bob hasn’t actually done anything yet. So now we have speculative return:

## Speculative Return = P/E Ratio Changes

Over long periods of time, if you take the entire stock market, you would expect the speculative return to be very negligible. This makes a lot of sense, right? In the end, you’ve got to show me the money! And history agrees. Over the last 100 years, the total annualized return for the total U.S. market was 9.6%, and all but 0.1% of that was explained by earning growth and dividends. (See graph below.)

Great, right? As long as corporate earnings growth keeps chugging along and we keep getting some dividends, we should be good to go. Over the past 25 years, the U.S. stock market has had earnings growth of 6.4% and an overall dividend yield of 3.4%. Nice! But wait – there was also a speculative return of 2.7% due to the overall P/E ratio expanding from about 9 to 18!

## Total Return = Fundamental Return + Speculative Return

As you can see below, that gave us really strong annual returns of 12.5% since ~1980. The problem is, this isn’t likely to continue. For one, dividend yields continue to drop, and are now about 2%. As Bogle states, even if you assume a continued corporate earnings growth rate of 6%, now you have a total of 2 + 6 = 8%. But the P/E ratio is not likely to get any bigger. If anything, history says it should shrink back a bit. If it goes back to 16, that alone will subtract 1% from expected returns.

Data taken from Little Book of Common Sense Investing, Exhibit 7.1

(If you don’t agree with the 7% number, make up your own based on your expected dividend rate, earnings growth, and future P/E expansions or shrinkage.)

As you can see, this shows that it is unlikely that in the next 25 years we will earn much more than 8% annually from stocks alone, and chances are it will be more in the range of 7%. Add in those bonds as you get older, and that return decreases even further. Food for thought…

My comment was – Will earnings growth rates increase, as companies are presumably re-investing money not paid as dividends in themselves? I sure hope so, but it seems like a lot to ask.

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1. Steve Austin says

Something is funny about that graph. Does it mean dividend *yield* or dividend *growth*? Yields are reported against current prices, so with the high prices due to speculation, yields should be down. If yields really did grow from the 100-yr mean of 5.0% to the late quarter-century mean of 6.4% in the face of a steadily rising market P/E, then that says something truly beautiful about dividends.

You mention a “continued corporate earnings growth rate of 6%”, but the colors on the graph make it look like the 6% is for “dividend yield”.

Maybe the colors of the bars are off as given in the key, or Bogle means div growth (not yield)? Or I can’t see shades of blue this early in the AM? 😉

Regardless of the components of each bar, I certainly get the important message that things (economic) revert to the mean. If the mean of something was 9.6% over 100 yrs, and was recently 12.5%, it should shortly be 7% or so. Of course, there are always people who will try to convince you that things are different now and so the mean is rising and will continue to do so. (And then they will try to convince you that you should use your money to purchase financial products from them, not the other guy who is saying returns will revert to the mean.)

2. Meme says

The dividend and growth series are mislabelled, or the text has it wrong.

3. Scott says

The problem I see with this example is that it discusses overall market averages with a single stock example. While I don’t disagree that averages (and index & mutual funds) will probably lower in the near future, there WILL be plenty of individual stocks which will outperform the averages.
This type of discussion just points out the neccessity of due diligence and understanding what you’re investing in. Everyone should recognize this from the late ninties when you could make money by buying anything that was a dotcom. Overall the market was doing well and people weren’t always choosing solid companies to invest in. Even while the market was correcting this century, there were still individual companies that were outperforming while 75% of the market was going down.

4. Mike H says

I have a feeling this projection is a little pessimistic, but that wouldn’t surprise me coming from the father of index funds. I understand the merits of being pessimistic, but I think this kind of talk could scare people away from the market. I don’t see the drop in dividend yield fall anymore or even stay where it is, it’s most likely a temporary thing. Pessimism about our economy never seems to come true, and I hope it stays that way.

5. Nyte says

This is pretty much what the second chapter of the four pillars of investing that you recomended was talking about as well. He also scared me a bit more talking about how yes the US stock market has returned about 10% but most other countries are no where near this level of return.

He mentioned the best thing that could happen for young investors (those just starting now and don’t have a considerable stock investment yet) would be another crash where we could all pick up very undervalued stocks without loosing much of our current investment. The problem is that would pretty much devistate those out there who are just entering retirement. The real question is how do we find that balance?

6. Dong says

I find 7% projection personaly just about right. 7% is still pretty good. I think it’s unrealstic to expect incredible growth year in and year out.

As for overall dividend yield dropping and rising, I think it’s really going to be function of tax policies. Net of taxes, we should be agnostic between earnings reinvestment and dividend yield, either way the money should be reinivested in growth. That said, i think large mature companies probably don’t do the best job reinvesting money and should pay out more dividends…

7. V says

the whole article is based on pure speculation

8. Steve Austin says

Mike, on the other hand do you have a feeling that projections of future mean stock returns higher than 9.6% are a little optimistic? In the same way that “this kind of talk” could unduly scare people away from stock investing, could you agree that the optimistic kind of talk could unduly attract them to it? (i.e. cause bubbles or frothiness)

Regarding a temporary (or any) drop in dividend yield, there are two components: prices have gone up faster than dividends have gone up, *dividends* have gone *down* faster than *prices* have gone *down*, or something in between. If dividends have been mostly relatively stable and growing (and they have been, given their nature), one might conclude that prices have gone up faster than dividends have gone up. Which when distilled is saying nothing more than that the trend of rising prices (relative to rising divs) is a temporary thing.

Regarding your final comment, I’ll add to it by paraphrasing Mauldin: “the optimists stick it out much longer than anyone expects them to at the time”. 😉 But hope is friends speculation, so it’s better if we just profit from others’ hopes when we can. 😉

(source: a lot of my above blabbering on divs comes from Jeremy Siegel’s books on them, and somewhat from Robert Shiller)

9. Don says

We can totally expect the next 10 or 15 years to have lower than expected returns. But you might not notice.

We had better than expected returns for the last decade and a half, and low inflation in general. Historically, after-inflation returns of the stock market have been around 4% I recall. That’s a good return, especially given that everything else tends to have after-inflation returns of about 0%.

What I think we’ll see for the near future at least is moderate returns but poor after-inflation returns, because we’re clearly having inflation problems. I’d be unsurprised if our 10-year after-inflation return was just to break even or be a bit negative.

While around here we like to tout 10 and 20 return scenarios for the stock market and point out that for long holding periods they pretty much trump the alternatives (i.e. better return and less volatility), we always do that without accounting for inflation. Accounting for inflation, we do periodically see 10 or 20 year periods where you lose money in stocks.

According to Shiller in “Irrational Exuberance” the 20-year period following 1901 had a real return rate of -0.2%. Of course it was followed by the run-up before 1929, so if you held longer, you did fine. He does point out that for the 15-year period after 1929 the real return was -0.5%, though, and it took another 5 years to move into positive territory again

Now Siegel, in “Stocks for the Long Run”, points out that long-term, stocks are generally a better hedge against inflation than other investments. So what do you do?

Personally, I was skeptical and conservative when I started my IRA in 1998 (that’s about when I began working). I picked a 60/35/5 mix of stocks/bonds/guaranteed and I didn’t worry about ups and downs. I weathered the crash better than most, and I am gradually becoming more aggressive. I expect the return to be poorer, but I don’t have better alternatives, so I’m investing in stocks.

Will I be disappointed by a decade of pathetic return? Yes, definitely. In a way. But a decade of pathetic return also shakes off the weak-willed, and their loss does contribute to my return so it’s sort of a schadenfreude situation. I personally think it is necessary, perhaps more so in these days when so many people understand the merit in index funds.

The market needs correcting behaviors. Why is it, that downturns are called “corrections?” Just PC talk for the news? Perhaps, but I find it funny to hear people talk about whether a particular downturn (they are presently experiencing) was a correction, wondering if it has quit going down so they can buy more. The way I look at it, it isn’t a correction unless it has shaken nerves, and more importantly has shaken off some folks who sell and decide to put their money somewhere else.

The run-up to 2000 was unprecedented especially in the context of inflation. It may require an unprecedented correction. With modern monetary policy, that is not likely to mean a tremendous crash the likes of which we’ve never before seen. It’s likely to mean a long period of stagnation, i.e. after-inflation stagnation. So the market may go up or down, but after inflation I suspect the answer is it may go nowhere or down and for a while.

Oh, and I think there’s about a 5% chance that the folks at peakoil.com aren’t just kooks and actually have some good insight. Their premise is that peak oil production is occurring and peak consumption is nowhere in sight (especially when you consider countries like China in addition to the US). Oil is still not expensive, adjusted for inflation. I have no way to predict what will happen when oil eventually does become expensive, but I suspect one part of it will be a period of poor stock market returns while we adjust to the new way of doing business and living.

10. Ted Valentine says

Very interesting. Malkiel has a similar take in Random Walk. Nothing wrong with keeping things conservative, because that allows for error. We can look at the past and look at recent trends all we want, but nobody can predict the future. That’s why this statement is so ubiquitous that people really don’t even notice it anymore: “Past performance is no guarantee of future results.”

I agree with this post. The two biggest mistakes people make when thinking about future returns are 1) not correcting for inflation and 2) using arithmetic instead of geometric means. When people say things like, “The stock market has returned 14% over blah blah blah” they’re making both these errors at once. Once you start correcting the data and getting lots of applicable data (including from outside the US), you start to realize that stock market returns are probably going to be 5-6% real returns over the next 20 years, and that includes a healthy risk factor. That doesn’t mean you shouldn’t invest for the future or retirement, just that if you’re counting on 14% returns over 20 years you are deluding yourself.

Great summary. I will check out or buy this book soley based on this excerpt/summary. The Taco Shack example makes it easy for a financial un-educated person (like me) to understand. Thanks!

13. Dutch says

I wonder if you could take your graphs and superimpose against the population growth for those periods. Why?

With 80 million baby boomers retiring over the next 15 years starting in 2010 you can imagine that they’ll be pulling money OUT of the stock market to spend on living expenses: food, medicine, shelter, clothing.

With so many pulling money out, how can you have 10%+ returns?

Just some food for thought.

14. Red says

THANK YOU, JONATHAN!!!!!!!!!!!

As I mentioned before……..I’m not a harbinger of doom, but I’ve been saying for quite a while (typically over at M*) that things are going to change.

Again, people think that 15-20% is easy and I keep trying to tell them…….IT AIN’T!

More than just the #’s, consider the business MODEL! We live in an information age. There is just too much info out there. Aside from the freaks like Google and Starbucks of the world (and hold on for Yahoo & McDonald’s to possibly ruin their party) think about how competitive everything in business is.

Profits, earnings…….heck everything is going down anymore. Wages will adjust as things get more expensive, but to be honest, I don’t see things going up based on a company’s gross profitability.

IOW, if there’s a company out there making too much money, somebody will find a way to do the same thing for less!!!!

Lastly………..watch out for the catalyst to this argument too (i.e. this being “ok”) where folks will start saying that 8% is OK because people are living longer, so they have longer for their savings to compound. It’s all good…….yeah right?

=^)

15. Carl Klemmer says

This isn’t nearly as simple as the diagrams make it look. First, dividend yield and P/E are intertwined – as the P goes up, PE goes up (along with this “Speculative Return”) and dividend yield goes down – so if P/Es drop that drives up dividend yield.

Second, and more importantly, dropping dividend payouts drive up earnings growth as the money is either invested in growing the company, or in buying back shares (which drives up earnings per share ). I think the situation where dividend yield and earnings growth both drop is unsupported.

16. Phoenix says

One presumption that isn’t as well accounted for in the effect of market increase is the effect of the source of money on the demand. Much more capital has gone into the market than has been withdrawn over the last 50 years. It’ll be interesting to see if that changes with the payout requirements for the Baby Boomers.

The retirement funding for Baby Boomers will have a direct effect on how much money is available to buy stocks, and obviously if more money taken from the pool of money to buy stocks (thereby reducing relative demand for stocks accross the board). This will have an effect on the relationship between speculative return vs. the fundamental return. My guess would be that speculative return would decrease with respect to fundamental return.

17. Steve Austin says

Nathan, doesn’t Bogle’s Exhibit 7.1, the Last 100 Years bar, violate both your Biggest Mistakes? It appears that 9.6% is nominal, not real. If one runs the numbers for divs and earnings over the past 100 years, one finds divs doing about 4% nominal and earnings doing 4.6% nominal. That’s only 8.6% nominal to Bogle’s 9.6% nominal. Is he using an arithmetic mean? My calcs use the data from http://www.irrationalexuberance.com/index.htm, the Excel download for stocks. I picked Jan 1904 and Jan 2004 as my endpoints. (Inflation was about 3.2% over the same period, which accords with the 5-6% figure you give. If that is the Last 100 Years real return, doesn’t one imagine even less for the near to mid future, given similar inflation, but earnings and divs reverting to the long term mean?)

18. Jonathan says

Steve – Yep, I messed up the graph legend. As usual I blame it on posting a 2am in the morning 😛

Scott – You’re right, in my example went from individual stock to total stock. Bogle didn’t do that, I did in order for it to make sense in my head.

However, you’ll have to point me to some proof besides the 2 or 3 same fund managers (out of 100s) that stock selection can be a learned skill. By investing in the total market, you remove individual company risk, and are simply left with the returns of the market as a whole.

Carl – Very interesting observation.

I still think this is very elegant. I’m sure all the other books like Random Walk and 4Pillars mentioned this, but this is the only book that drilled it through my thick skull.

19. Nony-mouse says

This is the same argument i tell my friends who say that I shouldnt have paid cash for my house.

If the stock market is GUARANTEED 7% or better (based on past performance), banks wont be giving out loans lower than that.

My friends always say that i should have taken a loan instead of paying cash and use that cash to invest in x funds, which will be more proftable.

20. I’m curious how this fits in with JLP’s study that the S&P 500 has returned 9.2% (real returns – after inflation) since 1926. Certainly that would strike me a long term gain, though with a somewhare limited index (only 500 companies).

21. Maury says

Jeremy Grantham of GMO (Grantham Mayo Van Otterloo) agrees that future returns will be disappointing… He is one of the best in the business. Essentially, the entire world is in a big bubble right now.

22. Scott says

Hi Jonathan,
I don’t have any proof that anyone can pick stocks better than the overall market — in the same way that there is no proof that the overall market will always outperform some particular set of stocks. You know how past performance doesn’t guarantee future results and all.
I guess I just feel that it is possible to put in the due diligence and find undervalued companies. Some of the the things I’ve read seem to indicate that we might be entering a period of sideways stock market where it’s not really up or down. I think those arguments make sense in that there’s not a really big catalyst to push things one way or the other.
There’s been periods of 10 or 20 years in the last century (if I understood it right) where this has happened. I think one was 1908 to 1920 (just before the run-up to the crash), and one in the late 60s until the 80s sometime. I guess that last one had several drops, but overall the DJIA approached 1000 but pulled back over the decades. The net effect being that the market average didn’t go anywhere (though dollar cost averaging would help you buy more when it was lower).
So, if the average of the market isn’t doing much, that could mean that half is doing above average, and half is doing below average. Or maybe it could be that 70% are below average, but 30% are significantly above average. I do think there are trends that you can spot, like aging Baby Boomers, and make decisions on which sectors are likely do to well over the next decade. From there, I do think you can do the due diligence and pick a handful of “best of breed” companies to invest in. Again, you could do worse than the averages, but you might do better. You’ll have to decide if its worth your time and money to accept the risk of “market average” — because that could be sideways or down as easily as it might be up. I simply prefer to be engaged and have a reason for essentially betting on a few companies than just hope that the market does well.
I should probably clarify that in my 401(k), I don’t have much of choice, but this is primarily what I do for taxable and IRA accounts.

23. Frank Kelly says

The problem with such simplified straw-men examples (based on historical averages) is that they over-simplify.

Nowhere there is there any accounting for event risk (another 9/11 or worse) country risk (war with China) etc.

The percentages are there for a reason (e.g. America wins 2nd World War and becomes super-power, increased world trade and improved financial stability raises international stocks) the numbers themselves are not the cause.

If you want the numbers for the future you need to predict who is going to win the next war and who will be stable (ouch!).

Bogle is going a little nuts in his old age – he’s been telling us to buy index funds and stop trying to predict the future (“stay the course”) but then he goes ahead and tries to predict the future.

Remember in 1990 no-one really foresaw the HUGE impact the web would have in 10 years – it has dramatically shaped our world and made huge impact on businesses and their productivity.

I’ve been hearing this “lower returns” argument since 2003-04 and since then my portfolio has skyrocketed

Trying to predict the future is a fools game! Even John Bogle (God bless him) can’t do it.

-Frank

p.s. Stay the course

24. stephen says

Hi –

I’m here from the future. Go long!