One of the most important concepts for the investor to understand is that of expected returns. Expected returns are, of course, not guaranteed returns, but an investor who doesn't have any idea of the range of possible future returns is likely to make significant errors in investing. A common error is to save too little. For example, an investor who expects an investment to return 15% when it only returns 5% will save far too little to reach his goals. Another common error is to buy high and sell low. This occurs when an investor doesn't realize that a risky asset class can drop 40%, 50% or even more over a relatively short time period. The investor panics and sells his investment to a more patient investor with a more realistic view of expected returns.
How to Estimate Investment Returns
So how does one estimate future returns? Probably the best place to start is in the past. If you're expecting an investment to return you 20% a year, but it's long term returns have been only 10% a year, then you're likely in for a disappointment. The overall US stock market, the most successful one in the world over the last century, has had a return over the last 110 years of 9.4%, approximately 4.8% in price appreciation and 4.7% in dividends. That number, of course, is prior to inflation, taxes, and investment expenses. Inflation alone has been 3.19% a year from 1913-2011 so the “real” (after-inflation) return has been 6.2%. You can subtract taxes and expenses from there. You can quickly see that any adviser who suggests you rely on “10% investment returns” to reach your goals is already setting you up for failure.
Although that is common, there are plenty of people out there who would lead you to believe that even higher returns are possible. Dave Ramsey, for instance, does a fantastic job helping people get out of debt. Unfortunately, once they're out of debt he recommends they get into “good growth stock mutual funds” which will then return them “12% a year.” Recently, there was a bust of a Ponzi scheme in my area where the investors were sucked in by promises of returns of 18% a year. If an investment is promising three times the long-term return of the stock market (which at one point lost 90% of its value), you can bet it will be at least three times as risky.
Where do Investment Returns Come From?
To make matters worse, many investing gurus are cautioning people that the future expected return of the US stock market is far lower than the past returns. To understand why, you need to understand where returns come from. John Bogle, in his investment classic Common Sense On Mutual Funds, teaches that returns come from three components, the dividend yield, the earnings growth of the underlying companies, and the speculative return. Over the long term, the speculative return becomes a non-factor. At times people are far too optimistic about the stock market, such as 1999, and they bid stocks up to ridiculous prices. At other times, such as late 2008, people are far too pessimistic, and stocks sell at a discount. But over the long run, these excesses cancel each other out.
So long-term returns really only come from the dividend yield and from the growth of earnings. Remember that from 1900-2010 about half the return came from dividends (4.7%.) Now, think about the current dividend yield of the US stock market, 1.8%. Assuming the earnings growth of the companies that make up the US stock market remains about the same in the future as it has been in the past, long-term returns going forward look to be about 2.9% lower than they were in the past. Is that assumption reasonable? Well, economic forecasts for the next several years call for growth of 1.9% to 3.1% per year. Luckily, that's an after-inflation number. So if the current dividend yield is 1.8%, and expected growth is 2.5%, a reasonable long-term expected real return on the overall US stock market would be 4.3% going forward. This is similar to how the Gordon model estimates future returns. To make matters worse, bond returns are also expected to be low in the future. It turns out that the best estimate of future returns on high-quality bonds is the current yield. The current yield of the US bond market is 2.8%. Unfortunately, that's a nominal, pre-inflation number. If you subtract out an expected 3.2% for inflation, you're left with a negative real return. So a portfolio composed partly of stocks and partly of bonds is likely to have an even lower return than the 4.3% noted earlier.
Expected Return on Investment Per Asset Class
So what is an investor to do? There really are only three choices. First, you can save more and for longer. This is probably the safest of the options. As discussed in on the future value function, we see that if you decrease the rate of return, you must increase either the amount added to the portfolio each year or the number of years the portfolio has to compound that return if you hope to arrive at the same place. Second, you can take on more investment risk. There are riskier asset classes than the overall US stock market. In general with investing, higher risk carries the possibility of higher return. Asset classes such as small stocks, value stocks, and emerging market stocks have higher expected returns than the overall market. Rick Ferri, in his excellent All About Asset Allocation (2006), lists the following expected returns for various asset classes:
|Asset Class||Real Return|
|Intermediate-term Treasury Bonds||1.5|
|Long-term Treasury Bonds||2.0|
|GNMA Mortgage Bonds||2.0|
|Intermediate-term Muni Bonds||1.0|
|Intermediate-term Corporate Bonds||2.0|
|Long-term Corporate Bonds||2.8|
|High-Yield Corporate Bonds||4.0|
|Emerging Market Bonds||4.0|
|US Large-cap Stocks||5.0|
|US Micro-cap Stocks||7.0|
|US Small Value Stocks||7.0|
|International Developed Large-cap Stocks||5.0|
|International Developed Small-cap Stocks||6.0|
|International Emerging Market Stocks||7.0|
While many would quibble about the actual values in this chart (especially given the current, hopefully temporary, low-yield environment) and the wisdom of investing in many of the asset classes listed, the point is clear. If you have a portfolio with a large number of small stocks, value stocks, and riskier international stocks, your expected return (and risk of temporary and permanent loss) is higher than that for one who holds only a US total stock market fund. Also, the lower the percentage of bonds you hold in the portfolio, the higher the expected return. Naturally, a portfolio composed entirely of emerging market stocks brings on its own problems and is NOT recommended. Lastly, an investor can hope that “alpha” can be added to his returns. This is the additional return possible from superior security selection and market timing. The number can be positive OR negative, depending on the skill of the manager, and, for all investors as a whole, is zero, before expenses (well below zero afterward.) Unfortunately, the data show that this skill is quite rare and probably shouldn't be counted on to add significantly to returns.
Estimating Returns Based on Current Valuations
Another reasonable estimate of future expected returns is published each year by Jeremy Grantham's GMO firm. This is updated every year based on current valuations. It hasn't been perfect in the past, but it seems to be relatively accurate. It suggests real returns for common asset classes over the next 7 years will be anywhere from -2% to 4%.
I'm sure to many of you the expected returns I've discussed above seem quite low. I know how disappointing that can be. But hope isn't much of an investment strategy. Given how low future expected returns are likely to be, it is all the more important that the wise investor reduce the bite of taxes and investment expenses on the portfolio returns.
The bottom line? Have a realistic view of what you can expect from investing over the long-term. If you do not, your investment plan will likely result in failure due to your own behavior. When estimating future returns for your portfolio, use after-inflation, after-tax, after-expense returns that are realistic, such as 2-6%.