Susie Poppick: 3 Simple Equations All Investors Should Know

Whether you love to buy and sell stocks or barely understand what’s going on in your retirement account, there’s a good chance you could benefit from learning more about the math behind the stock market.

Here are three fundamental equations that the savviest investors know. Relatively easy to understand, they will help you choose the right stocks and funds and, most important, keep your expectations about future returns grounded in reality.

Equation 1

S&P 500 dividend yield + about 4.5% = the expected long-term return on stocks

You can look up the current S&P 500 dividend yield, which is about 5% now, the 4.5% is how much you can expect dividends to grow based on the past. So today the expected long-run return is 9.5%. Adviser and author William Bernstein says thinking about this number brings you down to earth in boom years, and can reassure you when the market is down.

Equation 2

A 1.5% expense ratio = more than 40% of your money after 40 years

Put $100,000 into a fund with a 1.5% expense ratio, assume a 6% underlying return, and you’ll get about $560,000 after 40 years. With the same pre-expense return in a very low-cost index fund charging 0.1%, you’d have $990,000.

Equation 3

Net income / shareholder equity = return on equity

Return on equity is a classic measure of a company’s ability to put shareholders’ money to good use. (Equity is roughly the cash investors put into the business, plus retained earnings.) Calculate a stock’s ROE using the balance sheet and income statement.