Dave had published his expectations that the market would grow 12% on average and right until 2000 there was little reason to dispute this. Only, there was something wrong with Dave’s math even then. There’s a difference between the long term CAGR (compound annual growth rate) and the average return. Let me explain. If in one year, the market is up 20% and the next year it’s down 10%, you’d be inclined to add (-10+20)= 10, then divide by 2, for a 5%/yr average return, right? But, the way to calculate the CAGR is to take the returns, and multiply, 1.2*.9= 1.08. this is over 2 years, so you take the nth root, in this case 2, and get 3.92% per year. This may seem a minor difference, but it accumulates over time, and down years of say 33%, take a 50% increase to overcome.
Let’s look at the danger of relying on this magic 12%/yr number. First, if you wish to tinker for yourself, I wrote a small spreadsheet you can download to your computer. I start with the premise that (a) we shouldn’t count on Social Security, if it’s there in 30 years, treat it as a bonus. I also believe that 4% is the safe rate of withdrawal from your retirement account. This multiplies up to a requirement to have about twenty times your preretirement income saved as a lump sum, so you can withdraw 80% of your final income each year. Last I use 43 years of work, from age 21 to 63. When assuming a conservative 8% return per year, we find that we need to save 15% of our gross income. Not too crazy if you are dedicated to keeping your spending under control.
Now, if we run the numbers that Dave suggests, a 12% per year return tell you that you only need to save 5% per year. Wow, you think, I can really afford that, but 15% is crazy. You then find that after a decade like we just had, the compound return was a negative 1% per year. You see that by investing only 5%, you saved up about 42% (after losses) of your current income, and even if the market gets back on track, you still find you have only 15 times your final income. If the market return is a lower 8%, you retire with only six times your income, enough to withdraw less than a quarter of what you lived on prior.
On the flip side, by saving 15% as I suggest, even after this bad decade, an 8% return for the remaining time will put you at just under 18 times your final income, just a 10% shortfall. The reason Dave scares me is that even in my most optimistic days, I never assumed a 12% return long term. Not long ago, I wrote an article titled A Change of Plans, in which I looked at the S&P chart from 1980 through 2000 and extrapolate where it should have been 10 years later, in 2010: 3600, 4 times the value it actually was in 2010. Admittedly, I didn’t expect an entire decade to produce a loss, nor did I expect, as Dave did, to see 210% gains.
I’m curious what Dave’s followers did over the last ten years, have your expectations changed? Dave has only dug his heals in further, recently writing The 12% Reality. Sorry, I call it the 12% pipedream. Let me close with one question – would you rather plan for 8% and when returns are actually 12% or higher, find you can retire at 45 or 50, or would you plan for 12% and if the market stumbles even a bit, have to work till you are 70?