Buzz
Do you recall when Suze Orman advised us to stop wasting money on coffee and invest it instead? She suggested that the $100 we spend monthly on coffee could grow into a million dollars for retirement.
The issue with her calculation, as pointed out by many investment experts, is that it relies on a 12% rate of return. If you're using this rate to plan your retirement, you might be miscalculating how much you need to save.
If you ask a group of financial advisors what the average rate of return is—how much an investment will gain or lose over time—you’ll likely get a range of answers, from 4% to that ambitious 12%. This is because there are various ways to calculate it.
As Alessandra Malito explains for MarketWatch, you could be considering either the nominal rate of return, which excludes inflation, or the real rate of return, which includes it. "Ignoring inflation could result in losing thousands of dollars in purchasing power," she warns. If you're using a retirement calculator that doesn't factor in inflation, you might end up with an overly negative picture of your savings, leading to unnecessary concern about not saving enough.
Another factor influencing the rate of return is that it varies across different types of investments.
There are different rates of return depending on the investment type.
The stock market has an average long-term return of 10%. After adjusting for inflation, this drops to an average return of 7-8% per year. If you're invested solely in stocks, you can expect your investment to grow by this amount each year, even when considering major market fluctuations.
But most likely, your retirement account isn't made up of just stocks, right? You probably have some bonds too, which are considered less risky. So, it's no surprise that the rate of return for bonds is lower. The U.S. bond market's average return is around 6%, and when inflation is factored in, this return becomes slightly lower.
The challenge of calculating how much you need to save now includes an added complexity: You must project growth for two types of investments, each with its own rate of return. These are broad categories, and within them, depending on the type of stocks (large cap, mid cap, etc.) or bonds (short term vs. long term) in your portfolio, each subcategory has its own unique rate of return.
This is why experts often give you a seemingly arbitrary rate of return. There isn’t a single figure to rely on.
If you have a financial planner or advisor, they should be able to break down your investments by type, providing you with an estimate of how your individual portfolio might grow over time.
If you aren’t yet working with a financial planner, most retirement calculators will show you the rate of return they use. For instance, Bankrate uses a 7% rate of return for pre-retirement, factoring in an inflation rate of 2.9%. Nerdwallet’s tool lets you choose your own rate of return, but it defaults to 6% for a conservative estimate.
As mentioned before, retirement calculators can feel overwhelming. Even if they tell you that you’ll only be able to retire in 6,000 years based on your current monthly savings, don't let that discourage you from investing. Save what you can now. While understanding long-term factors is helpful, try not to overthink them too much.
