Passive income, personal finance and fintech.
As I'm building this portfolio I do need to have some expectations for the future. Something to keep me motivated throughout the years of this journey. To some extent my portfolio will follow the market, and I've therefore established some estimates for the long term return in the market. And to do so I've looked to the past.
In an efficient market prices are believed to move independent from the past. However, I have no better estimate for the future than the long term
returns we have seen in the past.
Although my portfolio does not consist of any stocks given in the S&P 500 index, I have chosen this as the market proxy. One could argue that I should find a better proxy for my market, but lets talk about that in a later post.
The table to the left shows the price of the S&P 500 index at January 1st the given year. The data is retrieved from Yahoo Finance.
A quick glance at the table might cause one to think that these are great returns, since an increase from $17.22 in 1950 to $2,278.87 in 2017 is a 13,133% return.
But we need to know the annual return of the market, and for this we can use the Compound annual growth rate (CAGR) formula.
I have calculated the CAGR of S&P 500 for different time periods from 1950 to 2017, illustrated in the matrix below. The highlighted cells are commented below.
Note that the above rates are not adjusted for inflation. The Norwegian Government has an inflation target of 2.5% per annum, which I need to take into account when considering my purchasing power.
Following the first diagonal you see the returns over a 10 year period, which varies from a high 15.53% to a low -2.58%. As you increase the holding period (next diagonal), you can see that the annual stock returns are more stable. For example a 30 year holding period varies only from a high 9.77% to a low 6.11% per annum.
Note that the CAGR from 2000 - 2010 is actually negative, which is explained by the financial crisis we had late in that period. But even when you include the bull market we've had after 2010, with a CAGR of 11.35%, you only end up with a annual growth rate of 2.93%. Just slightly above the inflation target of my home country.
Following the argument of more stable returns over longer holding periods I've ended up with the CAGR of 1950 - 2017 for my expectations, which is found to be 7.56%. This is a holding period of 67 years, which may be way to long for my lifetime, but shortening the period of 10 - 20 years does not alter the CAGR much.
To summarise I think it's sensible to expect a long term return of 7.5% for my portfolio. With an inflation target of 2.5% I end up increasing my purchasing power with 5% per annum. This is no way to get rich fast, but stead and slowly will do it for me.