2008-03-01

Diminishing Returns In The Stock Market According To Warren Buffett

I routinely read, see, or hear commentators or finance professionals plan or advise around an assumed annual return in the stock market of 10%—sometimes even 12%. But I have also been reading things here and again that suggest that it is a mistake to assume those returns—even if they have historical basis—will repeat in the future.

Most recently, Warren Buffett’s letter to the shareholders of Berkshire Hathaway came out last week; and two things stood out to me as to his view of what’s possible in stock market returns going forward.

First, the historical annual return in the stock market may be less than what people think:

During the 20th Century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3% when compounded annually. An investor who owned the Dow throughout the century would also have received generous dividends for much of the period, but only about 2% or so in the final years.

Second, he pretty much calls double-digit returns in the future fantasyland:

I should mention that people who expect to earn 10% annually from equities during this century – envisioning that 2% of that will come from dividends and 8% from price appreciation – are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. If your adviser talks to you about double digit returns from equities, explain this math to him – not that it will faze him. Many helpers are apparently direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many as six impossible things before breakfast.” Beware the glib helper who fills your head with fantasies while he fills his pockets with fees.
(See Warren Buffett’s letter at the Berkshire Hathaway website here.)

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