When we do financial planning for our clients, we use two key assumptions. An inflation rate and a rate of return on their investments. The difference between the two is called the Real Rate of Return. For example, if the market return is 8% and the inflation rate is 3%, you are 5% better off if you were investing in the market. Likewise, if you were holding cash, you have lost purchasing power as your cash buys 3% less than it did before.
For the last decade, we have had unusually low inflation rates. For the 10-year period from 2008-2017, the average inflation rate was only 1.35%. (http://www.inflation.eu/inflation-rates/united-states/historic-inflation/cpi-inflation-united-states.aspx). Compare that to the 10-year period from 1978-1987 where there was an average inflation rate of 4.62%. If you are still looking to achieve a 5%-real return, you would have only needed to achieve an investment return of 6.35% from 2008-2017 versus a return of 9.62% from 1978-1987.
However, we all tend to measure stock market success by comparing to our long-term averages. We think that if we do not get the average return of 10% for our equity holdings, our portfolio is not doing well.
Why does this matter? There has been talk by economists that we will have a hard time maintaining long term growth rates due to a variety of issues such as slower population growth. This may also translate into slower growth and lower returns in the stock market. However, if we are also able to maintain lower inflation rates than in the past, the overall stock market growth can also be lower and create the same level of wealth for investors.
So, when you are looking at your returns over time, remember that you should be measuring that return in relation to how much inflation is in the market also. If you forecast your expenses to grow at 2% and your portfolio growth at 7%, you will have the same buying power as if inflation grows at 4% and your portfolio grows at 9%. Make sure to factor that into your financial projections for retirement and longevity planning.