The Net Truth

Last year, a prominent financial planning newsletter editor asked his subscribers to estimate long-term future stock returns after inflation, expenses and taxes – call it a "net-net-net" return. Several dozen leading financial advisers responded. Although some didn't subtract taxes, the average answer was 6%. A few went as high as 9%.

They cannot be serious. Historically, inflation has eaten away three percentage points of return a year. Investment expenses and taxes each have cut returns by roughly one to two percentage points a year. So, in order to earn 6% for clients after inflation, fees and taxes, these financial advisors will somehow have to pick investments that generate 11% to 13% a year before costs.

Where will they find such huge gains? Since 1926, according to Ibbotson Associates, U.S. stocks have earned an annual average of 9.8%. Their long-term, net-net-net return is under 4%. All other major assets earned even less. If, like most people, you mix in some bonds and cash, your net-net-net is likely to be more like 2%.

Even the biggest investors are too optimistic. The Investment Fund for Foundations (TIFF), which manages $8 billion for more than 700 nonprofits, recently asked trustees and investment officers of these charities to imagine they can swap all their assets in exchange for a contract that guarantees them a risk-free return for the next 50 years, while also satisfying their current spending needs. Then TIFF asked them what minimal rate of return, after inflation and all fees, they would accept in such a swap. In TIFF's latest survey, the average response was 7.4%. One-sixth of the participants refused to swap for any return lower than 10%!

Faith in unreasonably high returns isn't harmless. It leads many people to save too little, in hopes that the markets will bail them out. It makes others ignore common sense, and believe in the claims of disreputable insurance and financial services agents who claim to offer ‘guaranteed’ but false returns. The end result is the same – a shortfall in wealth late in life, and more years working rather than putting your feet up in retirement.

Investors must seek the net-net-net truth. If a financial advisor says he/she can earn you 6% annually, net-net-net, say you’ll take it, right now. In fact, say you'll take 5% and let them keep the difference. In exchange, you will sell him/her your entire portfolio at its current market value. You've just offered the functional equivalent of what Wall Street calls a total-return swap.

Unless the advisor is a fool or a crook, your offer will be declined. Then you can determine a more rational rate of return, which is the number you should use for financial planning and analysis.