What kind of returns can investors realistically expect to earn on their portfolios? Some financial planners have used 8 percent as a desired annual rate of return for a balanced portfolio of stocks and bonds. That’s based on the historical performance of stock market and fixed income indices over the long term, going back 80 years or even longer. And considering a realistic inflation rate of 2-4 percent annually, and you can come up with a desired benchmark for overall real returns.
But the problem with using historic averages for market performance is they don’t necessarily reflect what will happen in the future. In fact, many prominent investors more recently have issued dour outlooks for long-term investment returns. Earlier this year, William Bernstein set a low bar of 2 percent over the next 20 years, net of expenses. Cliff Asness gave investors a slightly sunnier (or less gloomy) outlook, offering a projected real return between 2-3 percent for a 60/40 portfolio of U.S. stocks and bonds.
Forecasting is a treacherous game, even for distinguished investors and experienced portfolio managers. The future can look much different from today, and many of the factors that form the basis for today’s predictions can change and prove to be irrelevant down the road.
But there are good reasons behind these diminished expectations for returns and economic growth, including:
- We may be entering a cycle of Federal Reserve rate hikes, which typically serve to temper economic growth from getting overheated.
- As interest rates increase, bond values will decline. Higher yields may offset some of the losses in bond values. But starting from a low point in the current rate environment, the higher yields won’t be all that much higher.
- The current bull market is one of the longest on record. Just because a bull market gets long in tooth doesn’t mean it will expire. But markets are cyclical and it’s natural to expect a pullback after such a strong run of returns.
- Stock valuations are elevated, although not at the nosebleed levels that we saw just before previous bear markets. Improved earnings would bring valuations back to historical averages, but those trends are moving in the other direction right now.
What happens when your portfolio returns 2 percent a year instead of 8 percent? Such a dramatic difference in return assumptions can leave you with a shortfall right at a time when you may need the resources most, such as retirement. With not much time to close the gap, you’re only options may be to reduce your standard of living drastically in retirement.
How should you invest in a low-return environment? What changes you should make in your investment portfolio or financial plan? You could choose to invest more aggressively. But while your expectations for returns may change, your tolerance for risk likely will not. It would be a mistake to take on more risk than you are comfortable with, just to seek a few extra points of return. Risk is already increasing in a low return environment. Taking on more risk by investing more aggressively isn’t going to help.
Rather than being more aggressive with your investments, it can help to approach the financial road ahead like the cyclists in the Tour de France approach the mountain climbs they face — they may require a slower pace, but the better racers call upon their strength, stamina and willpower to continue their progress and eventually reach the summit of the hill. How can you be ready to tackle a long, strenuous climb toward your financial goals?
Strengthen your core
Your portfolio should be broadly diversified with investments across different areas of the market and all industry sectors. Often when we go through periods of strong market returns, holes can appear in our portfolio allocations. After some time, we may find we’re not invested or well represented in certain sectors. That can mean missed opportunities to capture some return if that sector starts to grow.
Because we don't know where future growth will come from, a broad and appropriate representation across all market sectors helps position our portfolios for growth opportunities, wherever they may emerge.
Broaden your perspective
One option you can consider is to look beyond domestic investments to overseas markets for potential growth. While international markets have been battered recently, many economists see potential for strong returns in select countries, with many areas starting to recover from a prolonged downturn and benefiting from weakness in their currencies versus the U.S. dollar.
But isn’t investing in foreign and emerging markets considered to be more aggressive? It can be, but there is a difference between being aggressive and being flexible. Investing in developed and even emerging global markets can be part of a smart asset allocation strategy, when it diversifies an overweighting toward domestic investments and fits with the other components of your portfolio.
Change your routine
Many investors are comfortable with the standard allocation to stocks and bonds for their portfolios. But like any routine, it’s easy to get into a rut that won’t benefit you in a low return market environment.
A change in that routine may help — breaking out of the stock/bond mindset to add other types of investments to your portfolio. For example, real estate is an option to consider when you’re looking to shatter the mold of stock and bond investing and add exposure to different parts of the economy that may offer the potential for higher growth.
Perhaps most of all, the potential for a low return environment means you should review the assumptions of your financial plan and be realistic about the possibilities for future returns. Changing your assumptions may require you to increase your savings rate to help close the potential gap between your savings and your anticipated needs. But you can also take the time to strengthen your portfolio to help you prepare for a market that may look much different in the future.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
All performance referenced is historical and is no guarantee of future results.
All indices are unmanaged and may not be invested into directly.
Stock investing involves risk including loss of principal.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio.
Diversification and asset allocation do not protect against market risk.