Kitchen Table Planning - Real Rate of Return

When you are working on your kitchen table plans, you will need to understand real rates of return. Your real rate of return is simply your investment return less the anticipated inflation rate.

For example if you have calculated your expected portfolio return at 8% and you anticipate that inflation will average 3% then your real rate of return is 5%.

This is important because over long periods of time inflation will erode the value of the dollars you have available to pay for a financial goal. If you are planning for retirement the dollars you will need to provide a certain level of income 20 years from now will be significantly higher than the dollars you need to retire today. If in fact inflation averaged just 3% over the next 20 years then todays dollar would only buy $0.55 worth of groceries when you reach retirement.

I see this often. Someone will say 'I have $500,000, I think I should be able to earn 8%, so I should be able to spend $40,000 each year.' Unfortunately this isn't how to achieve a worry free retirement. If you earned 8% you would have to reinvest 3% to offset inflation leaving you with 5% to spend. So the couple in the above example could only take an income of $25,000 from their $500,000 nest egg.

Or you may say 'I will need $1,000,000 to provide extra income in my retirement. How much should I be saving each year to end up with $1,000,000 when I retire?' Here you must use your real rate of return to calculate the payments required to reach your goal because you want to achieve the purchasing power of $1,000,000 today at some point in the future.

It is sometimes hard for folks to grasp this concept, but to come up with any real financial plan you must understand and know when to use real rates of return.

Kitchen Table Planning -Estimating Your Rate of Return

Many people do 'kitchen table' financial planning from time to time. They have a goal and make a guess about how much money they will need to pay for it. Next they will assume some rate of return on their capital and off they go, pounding on the calculator keys until they arrive at an answer. I am in fact a fan of 'kitchen table' planning, so I would like to offer some ideas on how to do it better.

I'll start with estimating your rate of return. Here is a method that will give you an idea about what sort of long term return you can expect from a portfolio using the three major assets classes available in the capital markets. Remember it is an estimate not a guarantee, but it is better than just pulling a number out of the air and it also illustrates the relationship between risk and reward.

To use this tool you should know that I am speaking of gross returns, that is returns before the effect of inflation. From 1925 to present the stock markets has produced and average annual return of 10%. Some years are higher, some are lower. Different periods have produced different result but I have more confidence in over eighty years of observations than any shorter period. Bonds have averaged around 5% and cash somewhere around 3%. You can use your own guesses of course but at least this gives you a starting point.

Next you must determine your asset allocation. That's just the fancy word for what percent of your portfolio is invested in each asset class. Just divide each component by the total. Now you can use the form below to estimate your long term return.




For example if you have 70% of your money in stocks, 25% in bonds, and 5 % in cash you would multiply .7 by.1 and put .07 in the contribution column, multiply .25 by .05 and put .0125 in the contribution column, and multiply .05 by .03 and put .0015 in the contribution column. Total the contribution column and you will get an 8.4% expected long term return from this portfolio.

Try changing the allocations to see how risk and reward can affect your expected returns. If you like you can add other asset classes such as real estate and commodities to see how they might affect your expected return.

Have fun.