The rate of growth is the single most important factor driving compounding. A growth rate of 5% doubles investments in 14 years, whereas a growth rate of 10% doubles the investment in 7 years.
Growth rates assumed have a huge impact when forecasting the size of funds that repetitively double inside Funds Generators. I use 4.5 % as the assumed average annual real growth rate net of costs and inflation. This article discusses how this 4.5% growth rate was determined and why this rate is both conservative and practical.
Forward-looking estimates
Most forward-looking investment statements include a valid warning that the future cannot be predicted by the past. Growth rates of the future cannot be predicted by growth rates of the past. Market fluctuations are sometimes compared to the actions of wild animals - anything can happen. Market volatility is especially concerning if you need to use the invested money in the short term.
But for a Ben’s Way Funds Generator, payouts are structured to be every 15, 25, or more years apart so annual variations are less impacting. When we look at the broad picture and consider average results decades ahead, we count on future results to be somewhat similar to the past.
For example, our retirement pensions are invested in a portfolio of financial instruments that may grow several decades before being used to pay our personal pensions. All pension funds are predicated on earning money decades in the future, much as they have in the past.
Investment prospects are the most relevant analysis for individual stocks. From the portfolio perspective, current performance is tied to economic outlook and market direction. However, over the long haul of decades, a portfolio's future value is expected to reflect past results over similar periods - it's all we've got.
In fact, the exact growth rate does not matter
Wait – wasn’t this article about the importance of the growth rate? Yes, growth rates drive compounding, but the time period is equally important in calculating the end amount. The final tally of the fund is the result of growth at a certain rate, at the end of an assumed time period.
We can choose to set payout triggers either by a target dollar level reached or by a target date set in the future. A payout trigger set at a particular date is far more precise and predictable than measuring a future dollar amount.
Target amounts in future dollars are unknown, as the rate of inflation is unknown, and sometimes calculation of inflation rates is itself controversial. To calculate inflation, questions arise, like, what elements of price changes are included, when are price measurements taken, or when are results reported? These all cause uncertainty and are open to interpretation.
For example, if the payout trigger is to give a portion of the funds to a charity when the pot equals $1M in today's value, it is hard to know when that dollar level will be reached. $1 M today might be $4.5M in future dollars, but perhaps could be $4.4 M or $4.6 M, depending on the source of the inflation calculation.
The easier option is to select payout dates and times. When payout dates are chosen as the trigger then, no matter how much is accumulated, payouts get made that day. At each date, the amount to be paid is always a portion of whatever the pot holds as stated in the future dollars. This calendar-based approach to arranging payouts is definitive, predictable, practical and repeatable.
How should a payout date be selected? A payout period of every 25 years is recommended because then the payouts occur on major anniversary years, 25, 50, 75, 100, and so on. Payouts should be a generational celebration, so aligning every 25 years with other anniversaries - such as the founding of a school etc, is ideal. The actual date and time during those payout years are at the discretion of the donor and the charities.
Twenty-five years recognizes the engagement of a new generation, the continuing support of older generations, and perhaps the passing of the duty of care for the funds from the oldest generation. All generations alive receive each payout to boost charitable funding. All generations alive can decide what portion of the fund to give charities now, and what portion to leave to grow for the future.
How 4.5% became the benchmark rate
Given a twenty-five-year assumed payout period, we now turn to calculate the expected average growth rate. The assumed 4.5% net growth rate was chosen because it simplifies discussions about payout calculations. A growth of 4.5% yields a tripling of investments every 25 years.
Tripling is a convenient way to talk in real dollars about what happens at a payout. During growth stages, the payouts are smaller, to enable growth. The tripling makes the decisions easy to discuss, by saying in the growth stage one-third is paid out, and two-thirds carry on to be tripled again. At the mature fund generator stage, two-thirds are paid out, and one-third is reinvested to enable further tripling and subsequent steady repetition. Very handy, but is 4.5% a valid growth rate?
To answer the validity question, we turn to the yearly performance of the Dow Jones Index of stock prices. The Dow Jones index is the longest-running measure of market performance, covering over 126 years. The Dow Jones growth rate, excluding inflation with dividends re-invested, from May 1896 (its inception) to August 2022 per: https://dqydj.com/dow-jones-return-calculator/ is 10.079% including inflation or 6.784% after adjusting for 3.295% inflation.
The costs to manage a fund generator must be subtracted to arrive at the net growth of the portfolio. From 6.784%, we subtract 0.9% for investment management, 0.8% for admin, and 0.15% for yearly taxes on income from dividends and capital gains. The result is 4.934% overall net annualized real growth over the length of time the stock market has existed. This supports that the 4.5% assumed rate is a conservative estimate.
Furthermore, if inflation were reduced (inflation is currently over 7%) to the stated targets of under 3% over the decades ahead, or if investment returns were larger than in the past (possible if efficiencies increase), or some combination, then actual rates may be even higher than the 4.5% chosen.
Factoring in market variability.
Averages like 4.5% are fine for making broad estimates, but what happens in reality, when market fluctuations are considered, over 25-year payout periods? If the market underperforms for a quarter century, it may overperform in the next. What should we expect?
To explore market variations, I have calculated the actual effective growth of 100 dollars over every 25-year period in Dow Jones history. These resulting various growth amounts were fed into a Compound Annual Growth Rate calculation to arrive at the representative constant growth rate for each actual 25-year market return.
For example, the up and down market variations from 1967 to 1992 would grow an investment of 100 in 1967 into a fund total of 1,043.7 in 1992. The 25-year CAGR for 100 to grow into 1,043.7 is 9.836% gross growth. Subtracting 3.295% for inflation and 1.85% for costs, we arrive at a net growth factor of 4.691% for the period of 1967 to 1992.
Similarly, we calculate the CAGR for every 25-year period over the history of the Dow Jones Index. Here are the results of those computations:
25-year CAGRs over 126 years of history of DOW JONES annual returns | Growth rates, including inflation and costs | Growth rates net of 3.295% inflation and 1.85% costs |
Median | 9.874% | 4.729% |
Average | 10.2% | 5.055% |
Highest | 16.39% | 11.24% |
Lowest | 6.15% | 1.005% |
Medians are the midpoint at which half the results are higher and half are lower. Per the table, 4.729% is the median return of 25-year periods of CAGR, a rate above the chosen 4.5% representative rate.
The highest and lowest return rates on the above table determine the variation boundaries - at least at this time. The lowest net return of 1.005% would be an unusually disappointing growth period. The good news is the next 25-year period is likely to be much higher.
Over the life of the Dow Jones Index, a 25-year term always had a positive CAGR% even after netting out costs and inflation.
What is next?
What should future Funds Generator managers do when 25-year results are average, high or very low? Payout strategies need to vary to reflect the actual performance achieved. The study of such strategies will be the discussion for next time.
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