Uncertain about market returns? Understand the Bogle formula and what it predicts for your investments. #StockMarket #InvestmentReturns #BogleFormula
Explanation in video
Hey everyone, John here! Welcome back to the blog. Today, we’re diving into something that might sound a bit like crystal-ball gazing: trying to figure out what kind of returns we can expect from the stock market. Now, I know what you’re thinking – “John, if anyone could predict the stock market, they’d be sipping coconuts on a private island!” And you’re absolutely right when it comes to short-term zigs and zags. But for the long haul, there are some sensible ways to think about potential outcomes.
Lila, my trusty assistant, is here with us too. How are you feeling about this topic, Lila?
Lila: “Hi John! Honestly, ‘expected returns’ sounds a bit intimidating. Is this going to be full of complicated charts and math?”
Not at all, Lila! We’re going to break it down, nice and easy. Think of it less like a perfect prediction and more like a weather forecast for your investments – it gives you an idea of what conditions *might* be like, so you can prepare.
So, What Are “Expected Returns” Anyway?
Great question to start with! When we talk about “expected returns” in the stock market, we’re not saying, “The market will go up exactly 7% next year.” That’s impossible to know for sure. Instead, it’s about looking at historical information and current conditions to make an educated guess about the average return we might see over a longer period, say 5, 10, or even 20 years.
Imagine you’re planting an apple tree. You can’t know exactly how many apples it will give you next year. But, based on the type of tree, the soil, and the climate, you can have a reasonable expectation of a good harvest over many years. Expected returns are a bit like that – an estimate based on known factors.
Introducing the “Bogle Expected Return Formula”
One popular way to think about these long-term expectations comes from a very wise man in the investing world, John Bogle. He was the founder of Vanguard, a huge investment company, and he was all about common-sense investing. He came up with a relatively simple way to frame expected returns.
Lila: “A formula, John? Okay, you said no complicated math, but ‘formula’ still makes me a little nervous!”
Haha, I hear you, Lila! But trust me, this one is more like a recipe with a few key ingredients rather than a scary math equation. Mr. Bogle suggested that the future return of the stock market will likely come from three main sources. Let’s look at them one by one.
Ingredient 1: The Current Dividend Yield
The first ingredient is the current dividend yield.
Lila: “Hold on, John. What exactly is a ‘dividend yield’?”
Excellent question, Lila! Think of it like this: when you own a share of a company’s stock, you own a tiny piece of that company. If the company makes a profit, it might decide to give some of that profit back to its shareholders. That payment is called a dividend. It’s like a little ‘thank you’ bonus for being an owner.
The dividend yield is just that dividend expressed as a percentage of the stock’s price. For example, if a stock costs $100 per share and it pays out $2 per year in dividends, the dividend yield is 2% ($2 divided by $100). So, if the overall stock market has an average dividend yield of, say, 1.5%, that’s the first part of our expected return.
Ingredient 2: Expected Earnings Growth
The second ingredient is expected earnings growth.
Lila: “Earnings growth… that sounds like companies making more money, right?”
Exactly, Lila! Companies are in business to make money – to grow their profits (or “earnings”). Over the long term, we expect good companies, and the economy as a whole, to grow. As companies earn more, their stock prices often (though not always!) tend to go up over time. So, if we expect businesses to grow their profits by, say, 5% per year on average, that 5% is another chunk of our potential future return.
Ingredient 3: Change in Valuation (The “Speculative” Part)
This is the third, and often trickiest, ingredient. It’s all about how much people are willing to pay for those company earnings. We often measure this with something called the P/E ratio (Price-to-Earnings ratio).
Lila: “P/E ratio? Uh oh, another term alert, John!”
You got it, Lila! And it’s a good one to understand. The P/E ratio simply tells us how much investors are currently willing to pay for every $1 of a company’s earnings. For example, if a company’s stock trades at $100 per share, and it earns $5 per share per year, its P/E ratio is 20 ($100 divided by $5).
- A high P/E ratio can mean investors are very optimistic about the future and are willing to pay a premium.
- A low P/E ratio might mean investors are less optimistic, or perhaps the stock is undervalued.
Now, here’s the kicker for expected returns: these P/E ratios don’t stay still. They go up and down based on investor mood, economic news, interest rates, and all sorts of things. Mr. Bogle called this the “speculative return” because it’s driven by sentiment more than the actual business performance.
If P/E ratios are currently very high compared to their historical average, there’s a chance they might come down in the future. If they do, this would actually reduce your overall return. Conversely, if P/E ratios are low and then rise, it would boost your return.
So, the Bogle formula looks something like this:
Expected Long-Term Return = Current Dividend Yield + Expected Earnings Growth +/- Change in P/E Ratio
What Does the Bogle Formula Suggest About Today’s Market?
This is where things get interesting. The original article we’re looking at, “Expected Returns in the Stock Market,” likely uses this Bogle framework to give us a sense of what the future might hold, based on where we are right now.
Let’s think about the ingredients today (and this is just a general illustration, actual numbers can vary):
- Dividend Yields: In recent times, dividend yields for the overall market (like the S&P 500 in the US) have been relatively low compared to some historical periods. Let’s say, for example, it’s around 1.5%.
- Earnings Growth: Businesses, over the long run, tend to grow. Economists and analysts might predict average earnings growth of around 5-6% per year.
- Change in P/E Ratio: This is the big question mark. If stock market P/E ratios are currently higher than their long-term average (which they have been at various points in recent years), then the Bogle model would suggest that there’s a possibility P/E ratios could shrink or “revert to the mean” over the next decade. If this happens, this part of the “formula” could be a negative number, pulling down the overall expected return.
So, if we add it up: 1.5% (dividend) + 5.5% (earnings growth) = 7%. BUT, if P/E ratios are expected to fall, that could subtract, say, 1-2% from that annual return over the next 10 years, bringing the total expected return down to maybe 5-6%.
Lila: “So, if P/E ratios are high, like when everyone is super excited about stocks, the formula might actually predict lower returns in the future? That seems a bit counterintuitive!”
It does, doesn’t it? But it makes sense if you think about it. If prices have been bid up really high (high P/E), it means a lot of the good news and future growth is already “priced in.” It’s like buying a popular toy at Christmas when demand is through the roof – you pay a premium. For future returns to be high from that point, things have to get even better than already expected, or prices have to keep getting even more expensive relative to earnings. If instead, excitement cools and P/E ratios drift back to more average levels, that acts as a headwind against future returns.
The key takeaway from the Bogle formula, especially when P/E ratios are elevated, is often that future returns might be more modest than the blockbuster returns we might have seen in the recent past.
Why Bother With These Expectations?
You might be wondering, “If these are just estimates, why should I care?”
- Planning: Understanding potential long-term returns helps you set realistic goals for things like retirement. If you expect very high returns, you might not save enough. If you have more modest expectations, you might plan more conservatively.
- Patience: Knowing that market returns are made up of these different components can help you stay patient. If markets are flat for a bit, but companies are still growing earnings and paying dividends, you know some positive forces are still at work.
- Avoiding Bad Decisions: When markets are flying high and everyone is euphoric (often leading to high P/E ratios), understanding that this might lead to lower future returns can help you avoid jumping in with money you can’t afford to lose, or getting caught up in hype.
It’s crucial to remember: these are NOT predictions or guarantees. They are tools to help us think more clearly about the future and manage our expectations.
What Can Beginners Do With This Information?
If you’re new to investing, all this talk of formulas and ratios might still feel a bit much. Here’s the good news: you don’t need to become an expert analyst to be a successful long-term investor.
- Focus on the Long Term: The Bogle formula is about long-term trends, not next week or next month. Investing is a marathon, not a sprint.
- Diversify: Don’t put all your eggs in one basket. Spreading your money across different types of investments can help manage risk.
- Keep Saving and Investing Regularly: Whether expected returns are high or low, consistently putting money away and investing it (perhaps through dollar-cost averaging) is a powerful strategy over time.
- Don’t Panic: Market ups and downs are normal. Stick to your long-term plan.
Knowing about expected returns can simply help you set a sensible course and stay on it.
John’s Thoughts:
For me, the Bogle formula is a great reminder to stay grounded. When stocks have had a fantastic run, it’s easy to think it’ll last forever. This framework helps me remember that valuations matter, and future returns might not always mirror the recent past. It reinforces the importance of a long-term perspective and not getting too carried away by short-term market noise.
Lila’s Thoughts:
Lila: “Okay, I think I get it better now! It’s not about knowing the future, but about understanding the different ‘ingredients’ that go into how our investments might grow. Learning about P/E ratios was interesting – it’s like a ‘popularity score’ for stocks, and if they’re too popular, they might not have as much room to grow their price further. It makes me feel a bit more informed, even if I’m just starting out!”
That’s a great way to put it, Lila! It’s all about being informed and making sensible choices for your financial future. And remember, the most important thing is to get started and keep learning.
This article is based on the following original source, summarized from the author’s perspective:
Expected Returns in the Stock Market