Why Knowing The ‘Rate Of Return’ Is The Key To Retirement Planning

Why Knowing The ‘Rate Of Return’ Is The Key To Retirement Planning
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Do you remember that time Suze Orman said we should take all the money we’re “peeing down the drain” on coffee and invest it instead? You could take the $US100 ($149) a month you spend on coffee, she said (yelled? I think she yelled) and end up with a million dollars for your retirement.

There’s a big problem with her maths, as many investment experts have pointed out: She’s basing that hypothetical investment on a 12% rate of return. And if you, too, are using that 12% to plan for retirement, you could end up with a skewed expectation of how much you need to save.

If you go around a room of financial advisors and ask them the average rate of return — how much an investment will lose or gain over a specific period — they might each give you a different answer somewhere between 4% and that lofty 12%. That’s because there are few ways to calculate it.

As Alessandra Malito starts to break it down for MarketWatch, she writes that you could be looking at either the nominal rate of return, which does not include inflation, or the real rate of return, which does include inflation.

“Ignoring inflation could result in thousands of dollars or more lost in purchasing power,” she writes. If you’re using a retirement calculator that doesn’t account for inflation, you could end up with a view of your progress that’s too negative, and is going to make you worry you’re not saving enough.

Here’s the other variable that sends the rate of return all over the map: It’s not the same for every type of investment.

There’s more than one rate of return

The stock market has a long-term average return of 10%. Adjust that for inflation, and you’re looking at an average return of 7-8% per year. If you invest only in stocks, you can expect your investment to grow by this amount each year after taking into account big market dips and peaks.

But you probably don’t have a retirement account that’s filled with just stocks, do you?

Now the maths problem of figuring out how much you have to save has an extra part: You have to anticipate growth for different types of investments with different rates of return. And there are even differences within the sane investment category. For example, the types of stocks in your portfolio (large cap, mid cap, etc.) all have their own different rates of return.

That’s why you get experts handing you a seemingly random rate of return. There is no one number to bank on.

If you have a financial planner or advisor, this person should be able to break down your investments by type to give you estimate of how your individual portfolio should grow over time.

If you’re not at the point of needing a financial planner just yet, most retirement savings calculators will show you the rate of return they’re using.

And as we’ve said before, those retirement calculators can be daunting. Even if they say you’ll be able to retire in 6000 years based on your invested savings each month, that shouldn’t scare you away from investing altogether. Save what you can right now. And while it helps to know what factors affect the long-term, don’t dwell on them too much.

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