Formula for Investment Return Explained
Today I’m going to introduce a simple formula for calculating investment returns.
I know many people shy away from investing. They think it is too complicated, and they’ve got a point with some of it. But it doesn’t have to be complicated.
In fact, it turns out some of it is pretty simple. There’s nothing too complicated about keeping fees low, diversifying and adding money at regular intervals.
As a matter of fact, it turns out that predicting investment returns doesn’t have to be complicated either.
There’s a well respected method of predicting returns called the Gordon Equation.
Esteemed Investment guru Bill Bernstein includes it in his great book The Investor’s Manifesto.
It works for broad market indexes, rather than individual stocks. And it is for the long term rather than the short term.
In other words, rather than using it to predict where Apple is going to be tomorrow, you should instead use it to predict the UK stock market returns for the next decade.
How to crunch those numbers
The Gordon equation is calculated like this:
Expected real return = Current Dividend Yield + Real Earnings Growth Rate
That’s just to say to estimate your expected real return you just add a couple of numbers together and hey presto.
You should be able to get the Current Dividend Yield for whatever broad equity market index you are interested in straight off the relevant fund’s website.
For example, a quick trip to Vanguard shows the following expected dividends (early march 2019).
Dividend Yield on Various Markets (Early March 2019)
- All World = 2.14%
- Developed Europe = 3.42%
- UK FTSE100 = 4.49%
- US S&P500 = 1.65%
- Emerging Markets = 2.63%
Easier still is the earnings growth rate. It is a single number! Bernstein suggests 1.32% as a real earnings growth rate.
In truth, this number is for the US, but other sources for different places seem to be in a similar ball park, so I’m going with that as a one size fits all.
So all you do is add this 1.32 to the dividend yield of your broad equity market index and you’re good to go.
Based on the above we can use the Gordon Equation to project the following long term returns:
Investment Return Predictions
- All World = 3.46%
- Developed Europe = 4.78%
- UK FTSE 100 = 5.81%
- US S&P 500 = 2.97%
- Emerging Markets = 3.95%
The UK looks good, developed Europe OK and the US not so good.
The Bad!
But just to be clear this isn’t a recommendation. Though it might be tempting to stick all your money in the FTSE 100, most investors are probably better off not doing that.
Placing the entirety of your money in one country’s equity market is risky. Just ask the Japanese and Chinese whose markets are well off their all time highs that occurred decades ago.
Individual stock markets can crash and take a long time to recover.
The Bottom Line
The Gordon equation could be a useful tool when used correctly. But its not an oracle.
Its predictions are by no means guaranteed. More of a in the right ball park more often than not than something to be wholly relied upon!
Personally, I think it can be used alongside some other great sources for planning.
Two highly regarded sources which I like are Vanguard and Credit Suisse.
In line with the calculations above, The Credit Suisse Global Investment Returns Yearbook 2019 predicts 3.5% long term for global equites.
And Vanguard is talking about global stock market returns in the 5-7% range. Taking the middle number 6 and knocking off a couple of percent for inflation leaves us with 4% real. Pretty much in the right ball park.
The bottom line is nobody knows for sure what investment returns are coming, but this tool used along side a trusted source like Vanguard or Credit Suisse can at the very least provide us with a number for future planning.
