Your expected rate of return is a critical element in determining how much to periodically invest to help reach a future goal. Since no one can predict future returns, the expected rate of return is typically estimated based on an analysis of past returns for various investments. So what return can you expect in the future for stock investments? The average annual return for the Standard & Poor's 500 (S&P 500) for the period from 1926 to 2006 was 10.4%, but you don't want to simply use this return without determining whether it is reasonable.*
A starting point for making that assessment is to review the equity risk premium. Since stocks are generally considered more volatile than bonds, investors typically expect a higher return. This excess return is called the equity risk premium. Although there are many complicated methods to calculate this premium, a simplified approach calculates the difference between total returns for large-company stocks and long-term government bonds.
For the period from 1926 to 2006, that difference was 4.5%.* However, the annual equity risk premium fluctuated significantly during this period. This may not be reasonable for the future for a couple of reasons. First, even though price/earnings (P/E) ratios have declined, they still remain at high levels. Since corporate profits are not expected to increase as rapidly in the future, P/E ratios may not return to previous levels. Second, a significant portion of the equity risk premium results from dividends, which are at low levels. Third, investors can develop a preference for one asset class over another, which can drastically change the premium.
If the equity risk premium does decrease in the future, total returns will be lower than historical averages. Only time will tell if this will happen. However, it may be prudent to consider a lower return for investment programs than historical returns would suggest.
* Source: Stocks, Bonds, Bills, and Inflation 2007 Yearbook. The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market. Investors cannot invest directly in an index. Past performance is not a guarantee of future performance.