Do Individual Investors Need a Reality Check?

Natixis Investment Management conducts a biennial survey of about 7,000 individual investors with at least $100,000 in investable assets. The survey queries investors about various topics, including their expectations for long-term returns. The most recent edition contained a puzzling tidbit: US investors responding to the survey said they expect stocks to generate long-term returns of 12.6% per year above inflation.

That number is actually down from the 15.6% figure reported in 2023. But it’s still way too high based on historical averages, which could lead to some unintended consequences.

The Likely Culprit: Recency Bias

If you’re only looking at a couple of years’ worth of data, the 12.6% figure might look reasonable, or even conservative. Nominal returns for the Morningstar US Market Index were in the neighborhood of 25% in both 2023 and 2024, and inflation rose about 3.4% in 2023 and 2.9% in 2024.

And if you simply take the arithmetic average of (nominal) calendar-year returns from 1926 through 2024, the result is pretty close to the 12.6% figure (12.4%, to be exact).

At risk of speculating too much, another contributing factor could be that investors responding to the survey might not fully understand how inflation impacts returns. Most reported returns are nominal, meaning that they don’t include any adjustment for inflation. Real returns, on the other hand, include an inflation adjustment and are almost always lower than nominal returns. A 12.6% real (after-inflation) return would be closer to 14.9% in nominal terms, assuming a 2% inflation rate.

Don’t Bring Me Down

A more realistic number for returns above inflation would be about 7.3%, which is the annualized return for the IA SBBI US Large Stock Inflation-Adjusted return index from 1926 through 2024.

Why is this number so much lower than the 12.4% simple average I mentioned above? First, it reflects the impact of inflation, which averaged about 2.9% over the same period. Second, it’s a geometric average that accounts for the basic math of how returns relate to each other over time. To use a simple example, you might think that a $100 investment that loses 50% one year and gains 50% the next would end up in the same place, with an average return of zero. But that’s not what actually happened. Instead, you’d have $50 at the end of the first year and $75 at the end of the next, for a total return of negative 25%. Another way to think about this is that it takes a bigger percentage gain to make up for a given percentage loss, which is why geometric returns are almost always lower than simple averages. Even though losses are less frequent than gains, they inflict more damage because of the effects of compounding.

Why It Matters

If investors’ return expectations are way too high, what are the potential implications?

One obvious danger of overly high return expectations is that they could lead to undersaving. Let’s say someone saving for retirement 30 years down the road has a goal of building up a $1 million nest egg in today’s dollars. With a return of 12.6% after inflation, you’d need to save about $250 per month or $3,000 per year to reach that goal. But using a more realistic return number of 7.3%, the required savings would be more like $772 per month or $9,264 per year. In other words, you’d need to save more than 3 times as much.

Similarly, using an overly optimistic return estimate could lead investors down a path of spending too much when they start drawing down assets during retirement. (To cite a famous example, personal finance guru Dave Ramsey has advocated using an 8% withdrawal rate for retirement spending.)

Anchoring on unrealistic return expectations could also backfire in another way: If actual returns turn out to be lower over time (which is a likely outcome), people who were hoping for more might be disappointed and stop investing in stocks altogether. It’s also worth noting that reaping the benefit of long-term returns on stocks means living through some painful periods. Real returns on stocks have landed in the red in 32 of the past 99 calendar years. And as shown in the table below, real returns can be negative over extended periods: Witness the 1.4% annualized loss during the 1970s, or the 2.6% annualized loss during the “lost decade” of the 2000s.

Final Thoughts

None of this is meant to detract from the extraordinary power of equities to build wealth over time. A 7.3% real return over time is still far better than historical returns on other asset classes, such as bonds and cash. I’m also wary of piling on the notion that individual investors are uninformed and not capable of managing their own finances. In this particular case, though, there seems to be a worrisome gap between investor expectations and a more realistic estimate of what we can expect stocks to return over time.