Setting a Return Expectation You Can Actually Plan Against

Kavita needs a number and every number she has been given is too high

Kavita is planning seriously and needs a return assumption. She has been quoted several, all of them confident and none of them explained.

The assumption matters more than almost anything else in her plan, because it compounds. An assumption that is a couple of points too high does not make the plan slightly optimistic; over decades it makes it wrong by a large multiple, and the error surfaces at the end when there is nothing to be done about it.

Three corrections are needed, and each lowers the number.

Correction one: use what compounds, not the average

The most commonly quoted figures are averages of yearly returns, and an average always exceeds the rate that actually compounds money — by more the more the returns varied.

On our own record the two differ by 3.58 percentage points, which does not sound like much until you compound it: the same starting amount projected at the average rather than the compound rate arrives at 2.2 times the true figure over the period. The identity behind it is in why an average return can mislead you.

If the number you were given was produced by adding up years and dividing, it is too high. Ask which calculation produced it. If nobody can say, assume it was the flattering one.

Correction two: plan for the portfolio, not for shares

Return figures are almost always quoted for equity. Kavita will not hold only equity.

Her portfolio's return is the blend of everything she owns, weighted by how much is in each. Money in deposits and bonds returns less than shares — that is why it is there — so the portfolio return is below the equity return by an amount determined by her allocation.

This is arithmetic rather than a judgement, and it is the correction most often skipped. The single most common planning error is a plan that projects a whole portfolio at an equity rate. Work out the blend from the allocation you actually intend to hold — choosing an asset allocation.

Note also that the allocation is not fixed forever. If you intend to reduce risk as a goal approaches, the return assumption should fall over the plan rather than staying flat — the glide path to a goal date.

Correction three: subtract what leaves

Three things come out between the market's return and yours, and all three are more certain than the return itself.

Charges, every year, whatever happens. The share of the outcome an annual charge removes over a long holding period is substantial and does not depend on the return at all — how investment fees reduce wealth.

Tax, when you sell, and in some cases as you go.

Inflation, if you are planning against a goal priced in today's money. Whether to subtract it depends on which units your target is in, and mixing the two is an error worth more than the whole projected gain — nominal return, real return and purchasing power.

Then stop using a point

Even a correct number is the middle of something wide. Over every fifteen-year period in our record, holding the index produced a typical result of +13.46% a year — and a worst of +8.59%, and a best of +19.37%. Fifteen years is a long time, and that is what the range still looks like.

So a plan resting on the middle is a plan that fails in roughly half of the histories it might encounter. The useful method is to plan at a figure nearer the disappointing end and treat anything better as a surplus, which is the opposite of how projections are normally presented.

Run the plan at three numbers rather than one: a conservative figure, your central one, and an optimistic one. What you learn is not the answer but the sensitivity — whether the plan survives the low case, and what you would have to change if it did not. That is the output worth having, and it is why why long-term equity returns remain uncertain is worth reading before fixing any assumption.

What the past cannot tell you

A caution about everything above, including our own figures.

The Indian record covers one country over one stretch that included a long expansion. It is what we have and it is not a law. A different economy, or the same one behaving differently, would produce a different table, and nobody inside the period knew which kind they were in.

There is also a specific trap in using recent returns. A period during which prices rose faster than the underlying businesses grew has, by arithmetic, borrowed from future returns rather than predicting them. Extrapolating a strong recent stretch is the most common way an assumption becomes too high — and a strong trailing figure carries no information about safety either, which is why good returns do not make a portfolio safe.

What to take away

Take the compound rate rather than the average, blend it for the portfolio you will actually hold rather than for shares alone, subtract charges and tax, and put it in the same units as your target.

Then plan nearer the low end of the range and check what breaks in the bad case. A plan built on the middle of a wide distribution is not a plan; it is a hope with arithmetic attached — and the value of doing this properly is that the disappointment arrives now, while there is still time to save more, work longer, or want less.