I am a fan of using the principle of compounding interest.  I believe it is essential to understand this to have long-term financial success, at least for most people.

Unfortunately, some of the same people who promote the understanding of compounding interest also tend to be long-term bulls on stocks.  They talk about historical returns, and they specifically talk about U.S. stocks, usually with optimistic outlooks on returns.

In a way, they have largely been correct up to this point.  Over the last century, if you invested in a broad-based U.S. index fund, you were probably successful if you stayed in long enough.  The Great Depression was obviously an exception, but there were other periods where returns were also low or negative.

I often hear an assumption of 8% returns.  Sometimes I hear as ridiculous as 10%.  The problem is that the people assuming these returns are not talking about running a business or buying real estate.  They are not talking about investing in yourself by gaining more skills and knowledge.  They are talking about financial investments, and specifically stocks.

I think this is a bad assumption.  You should not be basing your retirement plans on a return of 8% over the long run, especially in real terms.  You may get 8% nominal annual returns, but it isn’t going to do you much good if inflation is running at 4% or 6%.

Unless you are creating your own product or business, I don’t think you should count on 8% annual returns from passive investments, unless you are betting on extraordinary overall economic growth in the United States, and perhaps the whole planet. If we have a huge wave of libertarianism blow over this planet, then I think a relatively free market could possibly give us real returns of 8%, but even that may be a stretch.

Stocks and Inflation

I often like to point out that the overall rising stock market is largely a function of inflation.  Without monetary inflation, there would be no overall trend of stocks going higher.  Some individual stocks would go higher, and some would go lower.  But overall, the stock market would not continually go up, even over long periods of time.

People would invest in individual stocks for speculation that some might grow (capital gains), just as they do now.  People would invest in stocks for dividends.  Without the current distortions with taxes and regulations, dividends would be more common.  It is really the main fundamental reason for investing in stocks over the long run in a free market, but we live in a distorted market.  The whole point of buying into a business is to earn a share of the profits, which are the dividends that eventually should get paid out to shareholders.  If shareholders were never paid a dividend, what would be the point of being a shareholder, other than to sell your shares even higher to the next sucker?

In a society without monetary inflation, the overall stock market would likely be relatively stable over time.  You would invest in stocks for dividends.  Also, due to increased productivity, your money would likely buy more goods and services over time.  So even if your investments were not going up in nominal terms, they would be going up in real terms, as your money gained purchasing power.

Compounding Interest Over 2,000 Years

I like to use this example to illustrate my point about the unrealistic returns.  Let’s say that someone living 2,000 years ago invested one dollar.  This would have been the time when Jesus Christ walked the earth.  This investor was able to get a return of 8% every single year and reinvest the returns.  When he died, he passed on his investments to one of his children, who kept the investments earning 8%.  They never withdrew anything.  Each child kept passing the investments on to the next child.

After 2,000 years, how much would today’s heir have with the investments having earned 8% compounding for that whole time.  Using the Rule of 72, the investment would have doubled approximately every 9 years.

After just 500 years, the initial investment of just one dollar would have turned into over $50 quadrillion, or $50,000 trillion.  That is way more money than is currently in existence in terms of U.S. dollars.  And that’s just after 500 years.  After 2,000 years, the number would be so large as to be incomprehensible.

In other words, it would have literally been impossible to get 8% annual returns over the last 2,000 years.  It was not possible given the economic growth.

Even if you just had a 2% compounding return over the course of 2,000 years, how much do you think that would turn into?

Your one dollar would turn into about $158,614 trillion.  You could add up all of the world’s GDP over the course of history, and it wouldn’t match this number.

Again, this just shows that a 2% annual return over the last 2,000 years would have been impossible, at least in real terms.

Now, the last 200 years or so have been incredible as compared to the previous 1,800 years. We have had sustained economic growth that basically didn’t exist before.  Somewhere around the late 1700s and the beginning of the Industrial Revolution, economic growth took off, or at least this is when it became evident in retrospect.

I have no idea what economic growth will look like over the next 40 years, let alone the next 200 years or 2,000 years.  Most of the world lived in extreme poverty 200 years ago, and that is not the case now.  Very extreme poverty in the world is probably somewhere around 10%.  This is a significant drop just in the last few decades.

My main point in all of this is that you should not expect sustained 8% annual returns in real terms.  I think returns these days, to the extent we see them, are somewhat artificial.  I don’t think there is enough accounting for inflation. There are also bubbles that cannot be sustained.

You should not plan your long-term future with an expectation of 8% annual returns, or even 6% annual returns, unless you are actively investing.  You shouldn’t expect to just buy an index fund in the S&P 500 and watch your money double every 9 years, adjusted for inflation. It probably isn’t going to happen.