The stock market returns 4 %

People assume all sorts of wild stock market returns when they make their<br>financial calculations. Here are some numbers that show up on web searches:

6 %<br>8.4 %<br>10 %<br>10.1 %<br>11.3 %<br>11.5 %<br>13.6 %<br>16 %

These are all correctly computed under their respective assumptions, but they<br>are very misleading because whatever those assumptions were, they&rsquo;re not<br>relevant for most calculations. You should assume 4 % in your calculations.<br>Here&rsquo;s one way to arrive at that:

The S&P 500 has historically yielded 12 % per year before inflation.

But that&rsquo;s the arithmetic mean. Returns compound geometrically, so what we<br>actually want is the compound annual growth rate. The typical rule of thumb<br>is to remove half the squared volatility from the arithmetic mean. Volatility<br>is notoriously hard to estimate, but let&rsquo;s put it at 15–30 %. This leaves us<br>with a cagr of 8–11 % .

During the same period, inflation has been 3–4 % depending on which source you<br>trust. This brings the real (inflation-adjusted) returns down to 4–8 % .

On top of that, we have holding costs, transaction costs (e.g. rebalancing),<br>and taxes. These are different in different localities and vary by investment<br>strategy, but let&rsquo;s say they remove 1–3 % of return. The net cagr is,<br>then, 2–6 % .

In the middle of all our assumptions we find 4 % . That&rsquo;s a much more<br>reasonable number.