Realistic expectations about the future improves the planning process. And, it helps you make better decisions.
 
The planning process involves computing future values of your retirement savings.  To do these computations, we have to make assumptions about the future.  We plug in numbers for your savings rate, your withdrawal rate, a period of time, and a future rate of return. Unrealistic optimism about any of these items leads to less useful output.
 
You control some of these elements.  You determine how much you save and how much you withdraw.  In addition, you can also decide how long you intend to accumulate retirement assets.  However, future rates of return are completely unpredictable.

Creating Realistic Expectations

History doesn’t always repeat, but it often rhymes.  The data tells us stocks have generated a 10% average annual return for more than 92 years.  The next nine decades may show similar results.  But what about the next five to 10 years? Should we expect an average annual return of 10% per year?

The basics of  stock market valuation

Think of a used car.  Kelley’s Blue Book gives people an idea of the fair value of a particular make and model.  This makes it easy for you to determine if the same car offered locally is over priced or listed for a bargain.

 

You can also describe individual companies or the stock market as a whole as expensive or cheap. Dividing the price you pay by the profits tells us the price-to-earnings ratio. PE ratios above a certain level tell us when something is expensive. While lower levels describe it as cheap.
 
The average PE ratio for the US stock market since 1950 is 17.65 (the red line on the chart). Many people would consider the market fairly valued at this level. At year’s end, the PE ratio measured over 23, which indicates a more expensive environment.

How Has Valuation Impacted Future Returns?

We used data provided by Yale professor Robert Shiller from 1950 through the end of 2016.  We wanted to see how valuations influenced future returns.  So, we looked at the PE ratio at the end of each calendar year.  Then we computed the compounded returns for the next five and ten calendar years.

When valuations were below average, stocks generated above average returns in the future.  Conversely, when valuations were above average, future returns lagged well below their averages.

The Impact To Long Term Plans

Historical data does not pinpoint future returns.  But, it can shape our expectations.  Current PE ratios show equities could deliver below average results in the next 5 to 10 years.
 

The impact on savers…

Remember, lower returns change the math, and make it more difficult to achieve your goals.  To achieve similar results, you can do two things. First, you can delay your retirement. Second, you can try to save more. Both of these steps will help you offset the impact from lower returns.

 

The impact on retirees…

Lower future returns also increase the challenges when you rely on your nest egg for income. Ideally, you try to spend less than your accounts earn over time. If future returns are lower, it creates challenges. It becomes harder to increase your income in the future.  Also, it makes it harder to maintain a reasonable withdrawal rate.  Your withdrawal rate impacts how long your money will last.  
 
The value of the planning process lies in the quality of the assumptions used. You shouldn’t expect your plan to be a precise prediction of the future. But, realistic expectations can improve the information you receive. Then, you can then make better decisions about your future.