The first of Mr. Bogle’s three elements is the starting yield, or annual dividends divided by stock price, currently about 2.2%. Second is earnings growth, which historically has averaged about 4.7%. Together those sources constitute what he calls the “investment return,” because they are based on the cash that companies generate.
Third is the “speculative return,” or any change in the mob psychology of how much investors want to pay for stocks. The S&P 500 is priced nowadays at about $23 per $1 of earnings per share, or a price/earnings ratio of nearly 23.
If that ratio rose to 25 over the coming decade, that would be roughly a 10% increase — boosting stock returns by about one percentage point annually. On the other hand, if the P/E fell to 20, that decline of more than 10% from today’s level would lower the next decade’s returns by about one percentage point per year.
That 2.2% dividend yield, plus the 4.7% earnings-growth rate, equals a smidgen under 7%. If market valuations rise one percentage point annually, that would take average returns up to about 8%; if they fall the same amount, total returns would drop to about 6%.
None of these figures count inflation, which the Federal Reserve has targeted at 2% annually. Subtract that to account for loss of purchasing power, and stocks look likely to return an average of about 5% annually over time; bonds, less than 1%.