I am a huge fan of compounding interest.  It is a very powerful concept, and it is a concept that can serve you well if you learn it early enough in life.

If you make a 10% annual return on an investment of $100, then you will make $10 for the first year.  But if you reinvest your return ($10), then you will earn interest on that the following year, in addition to your initial investment of $100.  Therefore, you will earn $11 in the second year (10% of $110).

You don’t have to wait 10 years to double your money, earning $10 of a return each year.  According to the Rule of 72, you only have to wait just over 7 years to double your money.

I used that 10% assumed return as an example.  But I don’t suggest that you will get a 10% return.  Unfortunately, many in the community of financial advisors like to assume high returns.  I hear the 8% assumption quoted often.

The people using this assumption will correctly admit that nobody is going to get a return of exactly 8% every year.  You can’t find a bond or annuity that will pay that high, at least for a relatively safe investment.  This 8% assumption is supposed to be an average because supposedly that is the return you should expect from U.S. stocks.

You will hear something to the effect of: If you can put aside $100,000 by the time you are 30 years old, then you will have over $1,000,000 by the time you retire at 60, assuming an 8% return on your investments.

It is quite an assumption.  I could say: If you can practice shooting and dribbling a basketball a couple of hours per day, you too could be like LeBron James, assuming that you are 6 feet 8 inches tall and have lots of natural talent.

This 8% assumption isn’t just a little optimistic.  It seems flat-out ridiculous for any serious retirement or financial independence planning.  I think a more reasonable number is around 3% above inflation, but that may even be pushing it.

There are a few select individuals who will earn an average return of 8% per year.  They will be business owners.  They will be real estate investors.  Most of them won’t be stock market investors.

I know the standard Warren Buffett advice that you should stick your money in a low-cost index fund.  We all know that U.S. stocks always go up in the long run (said somewhat sarcastically).

I am always quick to remind people of the Japanese stock market.  It hit its all-time high in 1989 (reaching almost 39,000) and has come nowhere close to that number since.  Today it is around 20,000.  How has the buy and hold strategy been working out for the Japanese investor who put his money in the market in 1989?  It has almost been 3 decades.  Is he supposed to wait for 4 decades?  He still needs a return of almost 100% just to get back to his initial investment.

I understand I am using a bubble market at its peak for my illustration.  But it still makes the overall point.  I am not saying that U.S. stocks will be like Japanese stocks.  I am not making any predictions.  I am just suggesting the possibilities.

Since the 2008 financial crisis, the U.S. economy has not seen one year of 3% GDP growth.  While the GDP may not be the best statistic, it is useful enough in this case.

If an economy has had less than 3% annual growth for a decade, why should the average investor expect annual returns of 8%?

Again, I emphasize the word “average”.  There will be a select few who do earn these returns.  But can anyone just stick his money in an S&P 500 index fund and expect an average of 8% annually when the economy can’t even grow at 3%?

It is easy to make these assumptions now when stocks are in a bull market despite a rather lackluster economy.  But what happens when we hit a period of stagnation?  What happens when price inflation eats up your returns?

And that brings us to a very important topic related to all of this.  Does this 8% annual return assumption account for inflation?  In nominal terms, a return of 8% might easily be possible in the future.  But if price inflation is 8%, then you are actually losing purchasing power because you will be taxed on your 8% earnings at some point.

In any scenario of retirement or financial independence, you have to account for inflation.  It is probably the hardest factor to plan for.  You can’t make plans based on an assumption of 8% returns if price inflation is going to eat up your purchasing power.  Even with the Federal Reserve’s target of 2% price inflation, that still lowers the return quite a bit.

This is just one of the reasons I like the permanent portfolio.  It has an inflation bias.  You are more likely to get higher nominal returns during periods of higher price inflation.  This makes up for the lost purchasing power of your money.

I don’t think this 8% assumption takes into account overall economic growth.  If the overall economy is growing slowly, then you should not expect an easy 8% return over the long run.

Imagine if someone had taken one hundred dollars and invested it when Jesus was born over 2,000 years ago. (I know that U.S. dollars did not exist at this time and that $100 at that time would have been a lot of money, but just go with this example.)  If that person’s initial wealth, with reinvested returns, had been passed on down the family through the years, how much would that family have today having earned just 1% compounding?

After 2,017 years, with an initial investment of $100 at 1% annual return, it would now be worth over $50 billion.  If that person and his heirs had been able to earn anything close to 8% interest annually, then the family today would have more money than what exists in the world.  In other words, the 8% return was impossible.

If you don’t like the example in dollars, do the calculation in gold ounces.  If someone had invested one ounce of gold and it returned 1% interest (.01 ounces of gold) annually compounded, then the family would have over 500,000,000 ounces of gold 2,017 years later.  This is with a return of just 1%.  At an 8% return, it would be far more gold than what exists on the planet.  In other words, it wouldn’t have been possible.

Now, a family today with an inheritance would be thousands of times richer than the ancestors of 2,000 years ago simply because of the purchasing power and the choices available today.  There was no air conditioning, or televisions, or smartphones, or air travel, or cars, or refrigerators back then.

My overall point though is that this 8% assumption as an average annual return is a very dangerous assumption that is going to hurt a lot of people who currently think they are on the path to financial independence.  One major economic recession can ruin a lot of hopes and dreams quickly.  Unless we get great economic growth in the years to come, there is no reason to expect anything close to a consistent 8% annual return.

You should save some of your money and let it work for you.  This is being future oriented.  It is the mentality of the upper class.

What you should not do is delude yourself into thinking you are going to consistently get a return of 8% above price inflation on your investments.  If you are a great entrepreneur investing in your own business or businesses, then maybe you can make this assumption.  But for stock investors, you are chasing after a dream that will turn into more of a nightmare.

If economic growth stays anemic at below 3%, you should not expect 8% returns or anything close to it over the longer term.  It is better to be conservative with your estimates and have too much money than to overestimate your returns and wind up with too little.