The Market Averages 8% Per Year, But That’s Not Going to Help You in Retirement

The Big Nothing Burger:

Troy Sharpe: I’m sure you’ve heard that the stock market averages 8% or 10% per year over long periods of time. Well, I’m going to show you today why that means absolutely nothing in retirement and what you should know in order to give yourself the best opportunity for a successful retirement.

Hi, I’m Troy Sharpe, CEO of Oak Harvest Financial Group, certified financial planner professional, host of the Retirement Income Show, and also a certified tax specialist. We have a piece out, which was on Yahoo Finance this morning, but it was originally published on the Wealth of Common Sense blog. We’re going to link to this article in the description down below, but the blog recently put out the S&P 500 Annual Returns from 1977 to 1999, and then 2000 to 2022.

Medium shot man posing indoors

This is two different 23 year periods. We’re not quite through the end of 2022 right now, but the markets are down about 23% or so, the S&P 500. We’re using that data in these charts today that we look at. Hey, brief interruption right here. If you like the content on this channel, make sure to subscribe, make sure to comment down below and share this video with a friend or family member.

I want you to be clear. When we look at this, this is what 8% average returns looks like. If you go through all of these numbers, you don’t see 8% in here one time. The closest we get is about 7.5% in 1992. Then we have 2000 to 2022 here, where same thing, we don’t see one single 8% return. We have these many years of outsize returns upwards. We have some down years, some pretty bad down years over this 23 year period, and this is tracking to be one of those bad years, but we don’t see 8% anywhere on these annual returns as far as a specific return that we achieved. Now, when we’re in retirement and we extrapolate out and we use simple figures like 8% or 10%, this is what we’re missing. It’s the sequence of returns.

We have lots of videos on the sequence of returns on this channel, but in short, if someone retires right here and they’re pulling out 4% or 5% of their portfolio. Well, we’re pulling out 5%, we lose 9%. We’re pulling out 5%, we lose 11%. Were pulling out 5%, we lose 22%. That’s a pretty bad time to retire and take money out of the portfolio. It significantly shortens the life expectancy of your funds, wut what we should do in retirement is what we call a Monte Carlo Analysis. This is what we do for clients whenever we’re extrapolating out potential investment returns with respect to someone’s age, their estimated life expectancy, the risk that they have in their portfolio, their income needs, when they take social security, what we’re gonna do with taxes, potential health consequences, all of these different scenarios and random variables that we’re looking at from a retirement planning basis, we want to look at not an average return of 8% over time. Really in retirement, we shouldn’t even use 8% for retirement planning simulation, because one, you’re probably not going to be 100% stocks in retirement.

We do have some clients that are 100% stock, but their portfolio has what we call a very large capacity for risk, meaning the purpose of that portfolio is really just to grow and compound over decades and then eventually pass on to children or grandchildren, or charity. Most people who are depending on income from their portfolio in retirement, and depending on if you need 3% a year or 5% per year or whatever that is, we need a more diversified portfolio.

Using 8% average rates of return and extrapolating out in a spreadsheet, or in some software, you found online, probably not the best way to do it. We want to look at forward expectations for the specific asset classes that you’re invested in and that asset class mix or your diversified portfolio should change over time. This is where retirement planning comes in. It’s the first step of our retirement success plan in our retirement success process. We have to identify where is your risk willingness, meaning your willingness to stay invested, when markets go down. We have to find that downside boundary from an emotional standpoint.

Various ways that we can do this but understanding that we need to create some guardrails in retirement. If you think about bowling when you take your kids or grandkids and they put those bumpers in the lanes, those are essentially guardrails. We want to create an asset allocation mix to where there’s a very high probability that returns that we experience do not fall outside of those emotional guardrails, because the number one thing that will mess up a retirement plan is if you’re overly aggressive and you fall off the low side of those guardrails then you go to cash you start to make changes, you panic, you get emotional. It’s one of the most certain ways to destroy a long-term investment plan.

When we look at a Monte Carlo analysis based on all of the things that we’ve talked about there, we want to understand that we’re planning for stock market recessions, or stock market crashes. We’re planning for some good years. I wanted to show you one that we have up here, it’s just a simulated portfolio because we have a lot of very conservative clients that never want to see their accounts go down 20% or 25%.

I created a portfolio here using multiple asset classes, multiple tools. This is one hypothetical simulated Monte Carlo analysis, but we see we’re not using 8% average returns here. We do have some 8% in here but we also have some negative numbers as we go out. Now, this is a portfolio that’s designed to really not experience any big-time negative losses. The big takeaways here, don’t use 8% average returns when extrapolating out, especially in retirement because of the sequence return concept.

You’re taking income out of the portfolio. Whenever you take income and have losses, it magnifies the drawdown in your portfolio and sometimes you get into a position where you potentially may never recover. Second big takeaway here is we have to identify what that downside emotional guardrail is. You’re in a position to where you can stay invested through periods of market turbulence.

Emotional Guardrail:

Once we’ve identified what that downside emotional guardrail is, now it’s time to actually construct a portfolio based on risk management principles that get us into a situation where when we’re looking at these hypothetical simulations, we don’t see these massive downsides. This, again, very conservative portfolio using multiple tools across multiple asset classes. One of these simulations, and there’s over a thousand of these that we want to look at every single one of them, but we looked at several.

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We want to make sure that the recommendation for how we’re investing, first and foremost, falls within those guardrails. This way you can stay connected to your plan and stay in the markets with whatever allocation percentage we have there during periods of extreme market volatility like we’re going through right now. Finally, 8% average returns do not mean you’re going to make anywhere near 8% per year. There’s plus 20s and plus 30s and minus 20s and minus 30s with the equity portion of your portfolio.

We don’t want to get overextended in periods of good times because things can change pretty quickly. I want to show you these charts one more time. This is the S&P 500 broken down into two different 23-year periods. We have lots of outsized, upward returns, very good period to be invested in the stock market. Naturally, there’s a reversion to the mean. We have some down years, we have some more up years, we have some pretty big downs. Ultimately, all of this equates to 8% per year.

We don’t want to assume in retirement that things are going to be slow and steady, because as you see right now, what we’re going through is a period of extreme volatility. We’re experiencing one of these down years. Let’s not lose focus with the portion of our portfolio we have dedicated to equities and understand, long-term corporate profits increase about 8% per year. This has been true over many, many decades in this country. During times like this, have a plan. Stay invested according to your plan. Don’t get overextended and just understand what the stock market has done historically and anticipate periods like this, not only right now, but also in the future. Stick to that plan.