Future Expected Stock Market Returns

Stock market returns have (theoretically at least) 3 components:

• Rate of Inflation
• Risk Free Rate
• Equity Premium

The expected return is the sum of these three. Current inflation is about 2.2%; historically the long-term risk free rate of return is about 0.7% and the equity premium about 4.8%. The sum is 7.7% which is the expected rate of return of the stock market.

This may seem surprisingly low to some who recall long-term rates of return for stocks in the 9% to 11% range. However, long-term rates of inflation are about 4.7% and the sum of the three components using that inflation rate is 10.2%.

So don't be shocked if nominal (including inflation) stock market returns in the current environment are lower that you remember. Do remember that what you get to spend is the real return (returns after adjustment for inflation) which is expected to be about 5.5% in both environments.