Financial Freedom,  Making Money

Return Potential For Mutual Funds

The return potential for mutual funds over periods of 10-15 is about 16%, but the return you can reasonably expect is actually closer to 8%.

Most return numbers you see online exclude tax rates, but these numbers include U.S. tax rates.

I’ve written about the return potential for other types of investments:

Mutual funds are one of the best passive investments out there, but as far as straight up return potential, they rank near the middle.

What Is A Mutual Fund?

A mutual fund behaves very much like a stock. It has a price and that price goes up and down. The fund may also pay out dividends, which can be taken or reinvested.

A mutual fund pools together the money of many investors to purchase various assets, usually stocks and bonds. The price of a share in a mutual fund is dependent on the performance of the assets the fund owns.

So naturally, the return potential for a fund is dependent on the performance of the assets it owns.

Dave Ramsey claims that mutual funds can get you 12% return. Unfortunately, the 12% return is misleading. It represents a one year return average as opposed to a long term return.

While 12% is absolutely possible over shorter time periods, over longer periods of time (20 plus years) you’re highly unlikely to hit that number.

Top 10 Year Performances 2005-2014

When looking at return potential, it’s very important to take a longish view. At least 10 years.

NASDAQ has a write up highlighting the mutual funds that had the best returns between 2005 and 2014, and here is the data.

Fund Name10 Year Return
T. Rowe Price Health Sciences180.7%
Janus Global Life Sciences T165.9%
Fidelity Select Biotechnology Portfolio148.9%
Fidelity Select IT Services142.6%
USAA Science & Technology Fund104.9%
Fidelity Select Retailing99.7%
Fidelity Select Leisure76.3%
Fidelity Select Medical Delivery58.1%
Hartford Healthcare Fund HLS IA57.5%
Fidelity Select Health Care36.2%

The first thing to be aware of is that these numbers do not represent a yearly return. They are the return for that 10 year period.

So the best performing mutual fund was the T. Rowe Price Health Sciences fund and it almost tripled in value in 10 years (180%). That 180% return actually comes out to just under an 11% yearly return average.

And at the bottom of the list we have the Fidelity Select Health Care at a 36% return in 10 years. That actually comes out to a measly 3.1% yearly return average. And it made the top 10!

Now this particular 10 year period (2005-2014) included a pretty meaningful recession. The 2008-2009 housing crisis saw the stock market as a whole fall more than 30%.

Top S&P 500 Performances

An index fund is a type of mutual fund, and there is none bigger or more defining of the stock market than the S&P 500.

I did a rough analysis of the S&P 500 using my stock history analyzer and came up with the best performances (ignoring dividends).

The following table shows the best performances of the S&P 500 over various time periods.

Time PeriodStart DateBest Yearly Return
1 YearJune 1932146.28%
5 YearsMay 193229.47%
10 YearsAugust 199016.75%
15 YearsJune 198415.74%
20 YearsMarch 198014.38%
30 YearsJune 197010.50%
50 YearsJune 19499.58%
80 YearsMay 19407.51%

Now these numbers do represent one year return averages. So if you compare the 16.75% return average to the 11% (180% ten year return) from the section above you can seen that it’s absolutely possible to get 12% or better over long periods of time.

And in fact the above table is actually less than the real return because it does not include the returns from dividends, which are usually 3% or more.

So we can see that the return potential of the S&P 500 is well over 10%, possibly as high as 15-18% when you include dividends. But return potential is very different from expected return.

Average S&P 500 performances

When you look at the average return of the S&P 500, you get a more realistic view of what can probably be expected in the future.

I used my stock analyzer tool again to calculate the average returns of the S&P 500 (without dividends). Here were the results.

Time PeriodAverage Return
1 Year7.66%
5 Years6.28%
10 Years6.36%
15 Years6.61%
20 Years6.84%
30 Years7.03%
50 Years6.72%
80 Years6.32%

These numbers take the average of all the X year returns. So the 5 Years number takes the average of all the 5 year returns in the history of the S&P 500. And the 20 Years number takes the average of all the 20 year returns in the history of the S&P 500.

Again, if we include returns from dividends we would need to add around 3% to these numbers.

So that would put our long term expected returns around 9-10%.

Expected Return vs. Return Potential On Mutual Funds

A deeper analysis of the stock market and mutual funds shows that the returns we get end up being very dependent upon the time period we are alive.

Just because the best returns ever seen over a 15 year period is 18-20%, doesn’t mean it’s possible for YOU to get 18-20% returns over the next 15 years.

You may put your money in the best performing mutual fund and only get an 11% return over the next 10 years. That’s what those investing in the T. Rowe Price Health Sciences fund saw between 2005 and 2014. And that was the best of the best!

So while there is potential to see returns as high as 20% over longer periods of time, it is very unlikely. However, you can reasonably expect to see returns of 9-10% over long periods of time. Of course, it’s also possible to see worse returns.

Taxation On Mutual Funds

All the return numbers we’ve looked at so far ignore taxes. And depressing as it may be, taxes will lower the potential and expected return values on our mutual funds.

You will be taxed one way on your dividends, and taxed a different way on the increase in value of the shares when you sell them.

Dividend taxation

First thing to understand is that dividends are taxed every year. If you have $1,000 of shares in a mutual fund and you get paid out $50 in dividends during the year, that $50 will be taxed at the end of the year.

Dividend taxation can be complicated, and differs from country to country. Some countries have special rates specifically for dividends and others may treat it as personal income. At worst, it can be taxed at and at best it can be tax free.

For example in Brazil, there are no taxes on dividends. In several other countries there is a flat tax rate on all dividends. And in the U.S. dividend taxation is dependent on your income level and the type of dividend paid out.

The average taxation of dividends around the world seems to be around 20%. This changes our expected dividend return from 3% to about 2.5%.

Capital gains taxation

When you sell shares of your mutual fund you will also be taxed. This only happens when you sell though.

You are taxed on the value gained while you held the shares. So if you bought $1,000 of shares and then sold them at $1,500, you would be taxed on that $500 increase in value.

Again, depending on where you live, your capital gains tax rate can vary widely. Some countries don’t tax capital gains. Some tax a flat rate. And some tax more the more you gain.

For the purposes of this article, I’m going to assume we’re subject to U.S. tax laws and that we’re selling after having owned the mutual fund for more than one year.

This means our gains are subject to 0%, 15%, and 20% tax rates. Unless, you’re making over $500,000 off gains, the majority of your money will be taxed at 15% in the U.S.

Looking at our potential non-dividend return (14-16%), the U.S. capital gains tax brings those returns down to 12-14%.

And looking at our expected non-dividend return (6-7%), the gains tax brings us down to 5-6%.

Conclusion

Now we have enough information to calculate our final return potential on mutual funds.

So our return potential, meaning the best possible return we can expect based on historical numbers, is about 16%. We get this number by adding 2.5% taxed dividend return to the 12-14% taxed non-dividend return.

And our expected return, meaning the average return seen over time based on historical numbers, is about 8%. We get this number by adding the 2.5% taxed dividend return to the 6-7% taxed non-dividend return.

The final return numbers don’t quite compete with some other investments like real estate or business, but considering how passive the investment is, it’s a great option. If you don’t have the personality to attempt some of the more lucrative investing options, mutual funds might be your best bet.

Happy investing.

Michael

I'm living the path to financial success and sharing everything I learn in this blog. I believe in the power of cash flowing investments, due diligence and time. This is my journey so far.

I learned everything I know from books, podcasts, conversations with friends and family and of course through real world experience as a cash flow investor. And I'm always pushing to learn more.

To see my investing timeline, check out our about page

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