Where the “7% Return” Comes from in Investing
For some reason when I thought about compound interest, the first thing my brain went to was, “mountains.” Ugh. I don’t know.
The focus of this blog shifts in accordance with my own obsessions, so you’ve probably noticed a focus on investing recently (before that it was psychological approaches to changing your spending habits, then it was travel rewards, and now… here we are).
I like to think that, as a result of my frenetic obsession-switching, you’re going to get a pretty damn well-rounded free InTeRnEt EdUcAtIoN. What more could you ask for? #ReferAFriend
Back to basics
One question I started to get more when I’d post about investing surprised me: “What do I have to invest in to get the 7% return?”
I realized: I had failed y’all on hitting the basics first before diving into a veritable deep-end of early retirement drawdown strategies.
Blame me, not yourselves – let’s talk about why I always use 7% in my examples.
When I first sat down to write this post, I figured I’d find 1,000,000 pages of Google search results with proof for the average – but I was surprised to find the search results were a little bit more all over the place than I expected, and most of the articles quoted some Warren Buffett Bloomberg article that I was unable to actually find (you know how it is – one article links the quote to another, which linked to a different secondary source, which linked to the first blog I found… it’s a circular cluster, and while I’m sure the quote is legitimate, I couldn’t find the original Bloomberg piece that these blogs allege originally published the interview, so I’m hesitant to include it here).
In any case, Buffett’s interview quote mostly just offered an explanation for why the average return is 7% (it has to do with GDP, inflation, and dividends, basically).
Moral of the story? It sounds like this is more contested and discussed in the finance community than I originally thought.
In short, the average stock market return since the S&P 500’s inception in 1926 through 2018 is approximately 10-11%.
When adjusted for inflation, it’s closer to about 7%. [Since we’re talking citations in this post: Investopedia.]
The S&P 500 today is composed of the 500 largest companies listed on stock exchanges in the U.S., and it’s responsible for driving most of the growth in the total market.
1926 was almost 100 years ago, and a lot has happened in the last century – if we shorten our look-back period to “recent” history, so to speak, I love this excerpt from Investopedia that regales us with tales of bull markets, bear markets, and “black swans”:
“The most recent 20-year span, from 2000 to 2020, not only included three bull markets and two bear markets, but it also experienced a couple of major black swans with the terrorist attacks in 2001 and the financial crisis in 2008. There were also a couple of outbreaks of war on top of widespread geopolitical strife, yet the S&P 500 still managed to generate a return of 8.2% with reinvested dividends. Adjusted for inflation, the return was 5.9%, which would have grown a $10,000 investment into $31,200.”
Notice anything hilarious about this paragraph? Any major black swans missing? Perhaps a black swan that’s lost its sense of taste and smell? As you can see, we had three of them in 20 years, and the market’s still doing great. My perception of this? The market is resilient.
That’s about 6% from 2000 to 2020.
“You could repeat that exercise over and over to try to find a hypothetical scenario you expect to play out over the next 20 years, or you could simply apply the broader assumption of an average annual return since the stock market’s inception, which is 6.86% on an inflation-adjusted basis. With that, you could expect your $10,000 investment to grow to $34,000 in 20 years.”
What does this mean for you?
Whether we’re talking a 5.9% return or the 12.97% return we’ve seen over the last 10 years, investing in the S&P 500 is all but USDA-choice, FDA-insured to beat your savings account by a landslide.
To invest in the S&P 500, you have options.
You can either buy index funds (that have slightly higher fees, as a general rule, and are priced once per day — index funds usually require a higher “buy-in” as well) or you can buy ETFs (which are made up of the exact same thing but traded throughout the day like a stock and usually have lower fees).
Got it? Two options. Index funds and ETFs.
Because I am a Vanguard loyalist, I invest in Vanguard index funds and ETFs:
VOO is the ticker symbol for the Vanguard S&P 500 ETF.
VFINX is the ticker symbol for the Vanguard 500 Index Fund Investor Shares.
They’re basically exactly the same, except for the way they trade.
All major investment banks have their own version of this, and at its most basic level, the index fund/ETF has a little piece of each company in the S&P 500. For a list of these companies, check out this article. Think Alphabet (Google). Amazon. American Express. Southwest Airlines! Domino’s Pizza! These are big names, and instead of hitching your wagon to one, you get to buy a little of all 500 when you invest in S&P 500 index funds and ETFs.
Other banks offer a similar investment “product,” and I did a little poking around.
It looks like Schwab’s and Fidelity’s index funds are cheaper than Vanguard’s; VFINX’s expense ratio is 0.14%. VOO’s expense ratio is 0.03%.
While VOO is an ETF and SWPPX is a mutual fund, remember: They’re just different banks’ versions of essentially the same thing, an account that buys a little of 500 different companies.
So now what?
While I like to use Betterment for proper diversification, you can also buy these index funds and ETFs in your regular brokerage account, IRA, and (usually) 401(k). Now that you have some names to plug in, it’s as simple as searching and pressing “buy” with the money you’ve put into the account.
Getting a 7% average return (based on the historical returns outlined above) is as simple as that.
