Making Portfolio Predictions With A 7% Rate Of Return

How does the 7% rate of return on the stock market work?

There are some great financial tools out there that can help you project the future value of your investments. However, they can be confusing to use unless you understand what rate of return you should actually be using.

You might know how much you can invest, what your investment time-frame is and what portfolio value you want to reach. But…

This can all come undone if you don’t use the right rate of return. There are people that advocate a 5% rate of return, some 7% and others 10%.Then there is inflation to factor in, is this before or after these variable rates of return?

Who Wants To Be A Millionaire?

The question of how does the 7% rate of return on the stock market work, is a crucial first step. If you don’t fully understand it, it’s probably the equivalent of setting a flight plan for the UK to the US but ending up in Columbia.

Just being slightly off with investment or retirement planning could be devastating. Just being off my 2 or 3% can put 100k, 200k away from where you expect to be.

Say you use a target portfolio value of £1 million and you invest £1,500 a month for 20 years, then a 10% rate of return would get you £761,593 but 10% would push you to almost £1.1 million (£1,078,201 to be exact). I know which one I prefer to look at when calculating potential portfolio values!

The big question is when we factor in inflation, what rate of return on the stock market works best?£761k in 20 years will look significantly different from £1.1 million. Obviously depending on your outgoings that might be the difference between portfolio survival or failure.

So how should you calculate your rate of return including inflation. In short, how does the 7% rate of return on the stock market work? We all use this 7% as a reference point for predicting our future portfolios, so let’s break it down.

How Does The 7% Rate Of Return On The Stock Market Work?

Essentially, if you subtract expected inflation from expected return, you will get the expected portfolio is the equivalent of today’s value.

That means the portfolio value you anticipate you will reach in 20 years time, will have the same purchasing value as it does now. Your £1.1 million is still worth £1.1 million.

Without factoring in inflation, you would essentially be targeting a portfolio of £1.1 million in future pounds but it’s purchasing power would only be equivalent to £761K.

Obviously, the tricky aspect is ensuring that your two predicted values are accurate. With a 20+ year time-span we should obviously expect a margin of error.

Especially if you are investing across multiple economics, which is quite common if your portfolio is along the lines of the MSCI World Index or FTSE All Global Cap. These index funds cover regions across the globe and often emerging markets which are highly volatile in terms of both growth and inflation (amongst other key metrics).

For example, I am based in the UK but 60% of my portfolio is the US therefore, I am using an inflation rate from one country and the growth rate of another. Although US and UK inflation rates are somewhat similar, they could diverge in the future. Despite the added complexity and volatilty there are some specific reasons I choose to invest in a global fund vs a single fund such as the S&P 500.

Wise – (Formerly Transferwise) have actually launched a new ‘asset’ feature where you can convert money into the MSCI World Index. As you can see below, it takes a little as three steps. It’s probably one of the most accessible and easy investing apps I’ve come across. You can read about it in more detail by clicking here or setup your account now.

What Should We Expect In Returns From The Stock Market?

The S&P 500 average return is 10-11% per year for almost 100 years. So we can assume if you had money invested over an extended period of time (20+ years) you will get around a 10% rate of return per year.

You can use a CAGR stock market calculator to get exact returns over a specific period with or without inflation.

In this instance you need to ask how above or below you expect the returns over the next 20 years to be. We really have no way of knowing, so you may want to speculate across 3 different scenarios. The market returns:

1. 3% less than the average at 7%.
2. The same historical average of 10%.
3. Exceeds the average return by 3% at 13%

What Level Of Inflation Should We Anticipate?

In order to calculate our real returns is with the following calculation: “Nominal interest rate = real rate – (inflation + other premiums (e.g. investment fees))

Thus far, we have established that 10% is the “generally accepted” long term approximation of the annual rate of return on the US stock market proxies by the S&P 500, or thereabouts.

Now we need to establish an agreed rate of inflation.

The inflation rate in the United Kingdom has averaged 2.49% from 1989 until 2021 and this figure has been pretty stable until recent times. The Annual inflation rate in the UK jumped to 4.2% in October of 2021, the highest since December of 2011. Although this is nowhere close to it’s historical all time high of 8.50% (1991).

The annual average for the US is slightly higher at 3.5% for the US economy. Over the last 40 years (1979 – 2020) it has moved between a range of –0.4% and 13.5%. Again, this has picked up in recent times with inflation driving above 5% and expected to push higher.

Let’s assume that inflation will average out to 3% over the next 20 year period.

Now we need to account for inflation across these various scenarios. However, for the sake of simplicity let’s use our 10% growth value.

• 3% inflation = 7% real returns
• 4% inflation = 6% real returns
• 5% inflation = 5% real returns

How To Work Out How Much You Need To Invest

You can increase your monthly or yearly contribution in-line with or exceeding the level of inflation in any given year. This means that you would be stripping out one of the variable factors in your calculation and just basing your prediction on the performance of the stock market. However, this gives me a rather abstract portfolio value. For example, I know how much things cost in the present day and that gives me a point of reference for a portfolio value.

For example, I know that a portfolio value of £365,000 would allow me to spend £1,216 per month, which would cover my cost of living. I don’t know what these values will be in the future, so in order for me to understand I need a like for like comparison.

Therefore, you would have to adjust your living expenses in-line with compound investment growth, which although possible can get tricky. By contrast, adjusting your returns with the rate of inflation, gives you an easier to interpret portfolio value whilst adjusting for inflation.

How To Plan Your Journey To Financial Independence

Now that we have established the rough baselines for growth and inflation we can look to calculate our Financial Independence trajectories. For this you can use either my Financial Independence Planner or Financial Freedom calculator to do this.

The FI Planner will allow you to input your portfolio target number, time-line and expected growth rate. This will return you with a compound interest breakdown of your contributions and interest earned over this time.

The FI calculator will also return safe withdrawal rates (SWRs) for portfolio success based on the Trinity Study. Additionally, what you can expect your portfolio to grow based on your withdrawal rate. However, there is a massive caveat to SWRs because of a paper that Vanguard recently released, which suggests that the 4% rule might not work anymore.

The FInancial Freedom calculator works a little differently and will give you the amount you need to invest each month to reach your financial goal. This is again based on your portfolio target, retirement date and expected market growth.

Where To Start On Your Investment Journey

The good news is that it’s never been easier to invest in the stock market. Whilst there are the obvious institutions such as Vanguard and Fidelity, investing with them can feel arduous. With lengthy forms and complex decisions at every turn.

Luckily, there are a great selection of innovative Fintechs disrupting the wealth management market. They are making investing simple, accessible and just plain easy.

As I mentioned earlier Wise has recently launched an assets section of it’s app. Where you can move money from your cash account into assets. I managed to open up a MSCI World Index fund in no more than about 5 clicks. In plain english the MSCI World Index is a collection of 1500 individual stocks from around the world bundled together.

There are also apps which allow you to choose and track which Index funds or even individual stocks you want to buy all in one place. Getquin takes this a step further, not only has all those features but it’s own community, so you don’t have to do it alone.

So remember, to check out my Fintech For You page, to not only find unique ways to invest but to save money too.