“Face reality as it is, not as it was or as your wish it to be,” Jack Welch.
Alright, Jack, let’s face some reality. Investment returns for your average American investor over the next 10 years or so are not looking good. In fact, they’re looking bad. Actually, they’re looking terrible.
How bad? The best guess for a 60% stock/40% bond portfolio is ~4.0% nominal and ~2.5% real (above inflation) a year. Historically, you’d be looking at ~8.0% nominal and 5.0% real.
Yep, returns over the next seven to ten years could be around half of their historic average. Investors need to understand why this is the case and what they can do about it.
Why Are Expected Returns So Low
Predicting short-term (less than two years) and intermediate-term (two to seven years) investment returns is nearly impossible. However, when you go out a bit further, you can get a pretty decent idea of the range of returns that you can expect. Valuations on various asset classes aren’t a GPS, but they can point you in the right direction.
So, what are valuations on U.S. stocks and bonds showing? Pain, a lot of pain.
Let’s start with bond rates. Why start with bonds? Well, because bonds are easy. They tell you what they’re going to pay you over time. Throw in your best guess of inflation and you know what your real return (what you’ll earn on an investment above inflation – the only number that really matters) will be.
Ok, so what are bonds paying (yielding) these days? Not much. A 10-Year Treasury bond is paying about 1.5% a year. When you consider that 10-Year Treasury bonds have historically paid between 5% and 6% a year, you can see that bonds are paying far below their long-term average.
Alright, so what’s the expected inflation rate for the next 10 years? Unfortunately, inflation is also expected to be around 1.5%, which means that 10-Year U.S. government bonds over the next decade will be paying you right around zero percent a year above inflation. (Historically, 10-year Treasuries paid ~2.0% a year above inflation.)
Well, that’s not so great is it? But, hey, what about stocks? Stocks are the engine of growth, right?
Unfortunately, American stocks look a bit expensive relative to history. There are dozens of ways to value stocks, but they’re all pointing to the same place: U.S. stocks are poised to pay around 4.0% a year real return for the next seven to ten years. (Here’s a nice article showing how various valuation methods get to similar expected returns for big American stocks.)
Alright, let’s look at our 60% stock/40% bond portfolio.
60% (stock allocation) X 4.0% = 2.4%
40% (bond allocation) X 0.0% = 0.0%
Add those together and you get 2.4% a year real return. Throw in 1.5% a year for inflation, and you get ~4.0% a year nominal return.
If you’re thinking that this looks pretty bad, you’re right. Looking over the past century or so, we’ve seen times when bond valuations didn’t look good (as they do today), and we’ve seen times when stock valuations didn’t look good (as they do today); however, we’ve never a situation where BOTH stock and bond valuations look terrible at the same time. We’re truly in uncharted waters.
So, what do we do?
First, don’t panic. These expected returns are just best guesses. We could get better than expected returns or worse than expected returns. However, they are useful for planning purposes. When you have high valuations – like we do now – it’s extremely prudent to plan on lower returns because the chances are much higher that this will be the case.
Second, there are actions that you can take to improve your chances of achieving higher returns by properly diversifying your portfolio, something that we’ll look at in the next article.