Monday, July 25, 2005

Realistic Growth Rates for Financial Portfolios

According to Ibbotson Associates (www.ibbotson.com), the historical (1926-2000) growth rate on the S&P 500 has been in the range of about 10.7% per year. This represents a nominal measure that includes capital gains, retained earnings and the reinvestment of dividends paid. In real terms (adjusting for inflation -- the percentage change in the Consumer Price Index) this growth rate is roughly 7.7% per year (10.7% - 3.0 annual rate of inflation).

This started me thinking about how long it would take for someone with an average net worth, say around $50,000, to turn this sum into something significant. What would be a significant accumulation? How about the value of U.S. Gross Domestic Product 'GDP'?

Historically, Real GDP (RGDP -- growth in the output of an economy) in the U.S. grows at a rate of about 3% per year and stands at a value of $11,100,000,000,000 ($11.1 trillion).

Now given the nature of compound growth, it is only a matter of time before a smaller sum growing at a roughly 8% annual rate exceeds a much larger sum growing at a lower rate. How long will it take before my $50,000 will allow me to purchase all of the U.S. GDP? We can compute the answer using the following:

$50,000(1.08)N = $11,100,000,000,000(1.03)N
solving for 'N' we have:
(1.08)N / (1.03)N = $11,100,000,000,000 / $50,000
or
[(1.08)/(1.03)]N = $222,000,000

[1.0485]N = $222,000,000
or
log1.0485[222,000,000] = N
or
ln(222,000,000)/ln(1.0485) = N = 406 years!

Now I won't be around 400 years from now. According to these numbers, If I put $50,000 into the stock market today and am able to earn the historical rate of return of 8% per year, my descendants will be able to purchase the whole of U.S. GDP at that time. Too bad for the other 350 million people in the U.S. economy that try to buy food, housing, or education for their kids.

I realize that individual's do not just cash in their financial assets at a single point in time and go on a spending spree. However, as we talk about the stock market as a vehicle for Social Security Privatization, retirees in increasing numbers are going to do exactly that -- cash in. The value of these assets is based on the ability to convert this financial wealth in to real goods and services if someone chose to do so -- real goods and services produced and provided by an economy growing at a rate of roughly 3% per year.

Thus, I believe that eventhough it is possible for some investors to realize a rate of return of 8% or more, as we talk about large segments of the population building portfolios the realistic rate of return must be closer to the actual rate of economic growth -- 3%.

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