Warren Buffett runs Berkshire Hathaway, owner of 60+ companies, and is widely renowned as one of the most successful investors of all time. So when Buffett talks about buying stocks, smart investors are inclined to listen very carefully. Buffett claims that stock market investors should expect to receive an annual return of 6-7% over the long term.
When asked how he came to this conclusion, Buffett noted that the economy is expected to grow long term at a 3% annual rate (measured in GDP – gross domestic product). When coupled with an expected inflation rate of 2%, the nominal GDP would rise to an expected 5%. Stocks usually rise at the same rate as GDP. The last step is to add a 1-2% dividend payment rate, boosting total annual returns to the predicted 6-7% long-term.
Buffett was then asked why the stock market had enjoyed stronger performance as measured by the US stock market benchmark Standard & Poor’s 500 Index (S&P 500) in the past. In reply, he noted that – while the S&P 500 returned average annual increases of 18% between 1982 and 1999, this was unreasonably tainted by the favorable market at the time. Many investors polled in the late nineties said that they expected stock gains of 14-15% to continue – an unreasonable expectation in an environment of low inflation.
So, working on Buffett’s analysis, whenever I’m discussing investing in stocks I typically suggest to investors that they can earn an average of 7% annual return. However, I’m basing this figure on a few assumptions.
First Assumption: You’re Planning on Investing for More Than Ten Years
The reason for this assumption is that the stock market can be very volatile in any given year. For example, in the year 2008 we saw a huge dip in the stock market, resulting in a loss of 40% for many investments. On the other hand, we see gains in excess of 7% in other years. It’s when we look over the longer period that we actually approach a steady 7% average.
Second Assumption: You’re Making Broad-Based Investments
By broad-based, I mean something like the Vanguard Total Stock Market Index. The figure of 7% return is not applicable if the stocks you’re investing in are volatile, like the stocks of just a few companies, or even just one company.
Further Data Backing the 7% Assumption
The 7% figure is also backed by long-term data for the stock market. When you adjust the S&P 500 for inflation, including dividends, you’ll discover that the average annual return figure is exactly 7%. This data can easily be checked out.
So, based on Warren Buffett’s analysis plus the raw historical data, I’m completely comfortable using the 7% figure as an estimate for long-term returns on the stock market.
But, and this is a big but, there’s still one problem. There’s a saying that’s not only true of investing, it applies to almost everything in life – “Past performance is not an indication of future results”.
Stock Market Investments Can Be Very Worthwhile
Dedicated investors with the foresight and patience to plan for the future can certainly make great investments in the stock market.
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