The John Bogle Expected Return Formula

I caught Vanguard’s John Bogle on a recent Bloomberg interview discussing his simple formula for estimating future stock market returns:

I have a reasonable expectations kind of formula that I’ve been using for 25 years and it’s worked the whole 25 years almost perfectly. There’s some decades where it doesn’t work as well as it should but for the full period the reasonable expectations have been almost exactly the same as the returns actually delivered by the S&P 500. And it’s a simple system.

And that is you’ve got a dividend yield that’s 2%. Going back a long time it was four and a half or five percent, so there’s a loss right there, suggesting lower returns in the future. Earnings growth has been about 5%. I think it’s going to be very tough to do that in the future, maybe we can do 4%. And stocks are highly priced. The first two are what I call investment aspects of the investment return and the second one is the speculative return — that is what will people pay for a dollar’s worth of earnings. 

Bogle’s formula is this:

Future Market Returns = Dividend Yield + Earnings Growth +/- Change in P/E Ratio

He says this formula currently gives him an estimate of stock market returns in the 4-6% range, well below the long-term average that falls in the 8-10% range. You could quibble with some of the details here but I like the fact that this is such a simple model.

Bogle has actually outlined this one before on many occasions. In his book Don’t Count On It he even provided a long-term look at how this formula has played out by decade going all the way back to 1900. Here’s the data (with an update by me through the end of 2015):

screen-shot-2016-09-13-at-10-39-21-am

Dividend yields are much lower now than the were in the past (something that can be partially explained away by the increase in share buybacks) while earnings growth and the P/E multiple expansion or contraction have been somewhat more volatile.

What’s interesting here is how inconsistent the change in P/E has been decade-to-decade. At times high earnings growth has led to multiple expansion while other times it led to a contraction in the multiple people were willing to pay for earnings. Fundamentals matter over the very long-term but even over decade-long stretches investor sentiment can trump all. And the reason for this is because the P/E change is really a gauge of investor sentiment or emotions.

When investors are feeling good they are willing to pay a higher multiple of earnings for stocks. When they are feeling nervous they are willing to pay a lower multiple of earnings for stocks. The problem with trying to forecast stock returns is that you’re really trying to guess how people will feel in the future.

You could come up with a reasonable approximation of the impact of dividends and earnings growth over the coming decade and still be way off depending investor allocation preferences or where we’re at in the emotional phase of the cycle.

And Bogle said as much in his interview. He admitted, “I can’t forecast the future, let’s be honest about that. But I can make judgments using reasonable expectations about the future and it seems to me the handwriting is on the wall for lower returns than we’ve had historically.”

And that’s all you can really hope for as an investor when dealing with an uncertain future.

So what if Bogle’s formula is right over the coming years or even decades?

A few thoughts:

  • Adjust your expectations.
  • Have a contingency plan in place if your expectations aren’t met (save more, work longer, spend less, start a side business, take on a new career, etc.).
  • Plan for lower returns either way. If you plan for lower returns and it happens you’ll be ready for it. If you plan for lower returns and it doesn’t happen you’ll be even better off. But if you don’t plan for lower returns and it does happen you’re probably out of luck.
  • If you’ve missed out on the huge bull market in U.S. stocks since 2009, don’t expect to jump in now and see similar performance.
  • Diversify more broadly beyond U.S. equities in areas that have higher expected returns.
  • Behavior and fees will matter more than ever in a lower return environment.

Source:
Vanguard’s Jack Bogle on Index Funds, Negative Rates

Further Reading:
Does a Change in Expectations Require a Change in Strategy?

*Returns used here are nominal and don’t factor inflation into the mix, another potential reason for the changes in P/E multiples over time.

 

Download PDF

Full Disclosure: Nothing on this site should ever be considered to be advice, research or an invitation to buy or sell any securities, please see my Terms & Conditions page for a full disclaimer.

  • Bogle is one of many experts who have cautioned us to temper our expectations, and I tend to listen to experts like Bogle and Buffett. 4% to 6% nominal returns = 2% to 3% real. If they’re right, the next decade will look nothing like the 80’s and 90’s (when I was growing up and not invested!).
    Ben, can you explain the discrepancy between Bogle’s stated 5% earnings growth, and your chart’s 9.2% growth? The latter is one of the best we’ve seen.
    Cheers!
    -PoF

    • Eric

      I sure hope no one is expecting stock returns like we had in the 1980s and 1990s, the S&P 500 returned +18% a year for two decades! Now, from 1980 to 2009, the S&P 500 did +11%, and +9% from 1926-1979. I doubt something in the 8% to 10% range in the next few decades is as outlandish as many believe, especially the CAPE’d crusaders.

      • John Richards

        I think most internationally diversified 60/40 or 70/30 portfolios are in the 6-9% return range YTD despite the S&P being only around 4-6%. This demonstrates the power of diversification and shows that there is still much to be gained over the next decade with a properly structured portfolio. I’ve set my CAGR assumptions to be down about 1% over the next decade (vs my current long term average CAGR) for planning purposes, but I also look at worst case (down 4%) and best case (up 4%) scenarios as well

      • John Richards

        I think most internationally diversified 60/40 or 70/30 portfolios are in the 6-9% return range YTD despite the S&P being only around 4-6%. This demonstrates the power of diversification and shows that there is still much to be gained over the next decade with a properly structured portfolio. I’ve set my CAGR assumptions to be down about 1% over the next decade (vs my current long term average CAGR) for planning purposes, but I also look at worst case (down 4%) and best case (up 4%) scenarios as well

      • John Coumarianos

        Eric — you need more multiple expansion from here to get 8%-10%. You start with 2% yield and 5% growth for 7%. Then you need more multiple expansion to get 8%-10%. How likely is multiple expansion from here?

    • Mark Massey

      That is assuming inflation is 2 to 3% annually. And I think Bogle is talking about US large caps only. If you are better diversified than just large caps and just domestic equities AND have the behavioral characteristics to not shoot yourself in the foot, you will likely do better than 4 to 6% nominal annual returns. Inflation could be lower than 2 to 3% over next few years.

    • Ben

      Basically the reason earnings growth has been so high this decade is b/c it cratered in the financial crisis, so this is just mean reversion and has to do with how the calendar worked out for 2010 and on.

  • P Murt

    S&P falls 1.5% as The median household’s income in 2015 was $56,500, up 5.2 percent from
    the previous year — the largest single-year increase since
    record-keeping began in 1967.

    • Eric

      Wasn’t household income just reported yesterday? S&P 500 is up 10.7% in last 12 months. Setting aside, of course, the almost infinite number of variables that drive stock prices, this seems totally reasonable, no?

  • P Murt

    S&P falls 1.5% as The median household’s income in 2015 was $56,500, up 5.2 percent from
    the previous year — the largest single-year increase since
    record-keeping began in 1967.

  • Eric

    Ben,

    Great summary. Really gives you a sense for how variable/volatile and unpredictable the inputs are. Now imagine the insanity of trying to accurately forecast these inputs across a range of 8-10 global asset classes (US, Int’l, EM large/small and growth/value).

    You very quickly get to a “historical average +/- a few percent,” learn to embrace the uncertainty and focus your efforts not wasted on forecasting towards sticking with your plan…

    • John Richards

      Agreed. If you want to put in a lot of extra work, you can place bets on mean reversion, but the benefit to work ratio is poor. If you feel good about your portfolio on the basis of past performance and overall risk, put it on autopilot, check it once a year, and enjoy life! You’ll still likely beat most active investors by a significant margin.

    • John Richards

      Agreed. If you want to put in a lot of extra work, you can place bets on mean reversion, but the benefit to work ratio is poor. If you feel good about your portfolio on the basis of past performance and overall risk, put it on autopilot, check it once a year, and enjoy life! You’ll still likely beat most active investors by a significant margin.

  • Socrates

    Indeed, managing expectations is important in an “Elysium” type of environment.

    In my own personal experience here in Canada, regular capitalist oriented investor types and private sector workers can expect significantly lower returns going forward, as well as permanent unemployment, under-employment, job insecurity, redundancy, compressed wages, longer
    working hours, no pensions, little vacation, and increased taxation. Not so for public sector workers. Government employees are the new 1%, and their salaries and benefits are on an exponential curve, increasing 2 – 3% compounded year in and year out.

    How this will be funded by an ever shrinking private sector with smaller profits remains to be seen. The wealthy of the future will have a close relationship with government, not with the private sector as we’ve seen in the past.

  • John

    “Earnings growth has been about 5%.”

    Where is he getting this from? S&P 500 earnings have been negative in recent quarters…

    • John Richards

      I believe that’s a historical figure, long term. If you look at the chart by decade, that’s pretty close. Looking at a few quarters is insufficient data to support any kind of long term forecast, and Bogle knows this, so it’s unlikely he was even thinking about the past year or two when he made that statement.

    • Ben

      Yeah he’s just making a long-term estimate over many years.

  • tagyoureit

    The three instances of >9% Earnings Growth immediately triggered a false pattern in my mind. P/E contraction should occur on profit taking.

    2010s P/E expansion due to QE?