Outside the Box: I need help to figure out the rate of return on my retirement accounts

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Q: What rate of return can I expect safely on my retirement accounts ($1 million) if I am not risk averse and can accept market ups and downs? Plan is to not take any money from these accounts until 70½. I know, lots of variables, but I am tweaking my planning sheet and want to determine if my numbers are reasonable. I am using 8% for my working future and 4% once I retire.

A.: Reducing your assumption at retirement from 8% to 4% suggests you expect to be more conservative once you retire. That’s a reasonable assumption. Many people do that, but many others do not because they find the volatility of the markets don’t bother them. You won’t know what you will decide until then.

So 8% and 4% are historically reasonable if you have a high percentage of your money in diversified stocks. However, there are many academics who think future returns may be below average going forward because valuations are above average so it may make sense to see how things look with lower return expectations.

Keep in mind, though expectations for returns are lower, very few predict stocks will fail to do better than bonds over long periods of time so continuing to own a significant percentage of your holdings in stocks is still a good choice for the long term.

The tricky part about projecting 8% or any other number is that you can average 8% but mathematically you won’t compound at 8% unless you actually get 8% every year. For instance, if you invest $1,000 and earn 8% every year, after three years, you have $1,260. But if you earn 20% in year one, 8% in year two and lose 4% in year three, you averaged 8% a year but only accumulated $1,244.

No portfolio with a large proportion in stocks has earned a steady return every year. It just doesn’t happen, doesn’t come close to happening, and probably never will happen. I recently saw a breakdown of year by year returns for a globally diversified portfolio consisting of 85% stocks and 15% bonds from 1999-2017. The portfolio averaged 9.35% but in only two of those 19 years was the return within 3% of that average, ie between 6.35% and 12.35%. In eight of those years the return exceeded 15% and the portfolio lost money in four.

As a result of the volatility, straight line projections can be misleading. A more robust method is to incorporate variability of returns into your analysis. This is most commonly done using a “Monte Carlo simulation.” More retirement calculators are incorporating MCS. Just be sure you understand the assumptions being made and the adage “garbage in, garbage out” because even a better technique can be misleading if the assumptions are bad.

If you have a question for Dan, please email him with “MarketWatch Q&A” on the subject line.

Dan Moisand’s comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.