Looking at Future Portfolio Returns

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jul 28, 2016 3:00:20 PM

and tagged Investing

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portfolio returnsThe past two days, we’ve considered the likelihood that future returns for bonds and stocks will be disappointing.

Now, we get to the punch line: what does this mean for our own investments? And is there anything we can do about it?

Let’s put some numbers around the conclusions of the previous posts. For a portfolio that is 60-percent stocks and 40-percent bonds, the grid below shows what returns might look like. (For the record, I used the current yield-to-worst on the Barclays U.S. Aggregate Bond Index for bonds, and an average projected return for S&P 500 stocks, rather than the lower figures I highlighted yesterday.) This is a reasonable, middle-of-the-road estimate, in my opinion.

Returns from

Past 40 years

Past 20 years

Past 10 years

Expected*

Stocks

11.00%

7.87%

7.42%

6.0%

Bonds

7.68%

5.67%

5.13%

2.0%

Portfolio

9.67%

6.99%

6.50%

4.4%

*Expected returns are projections and are not guaranteed.

There are a couple of key points to note here. First, returns have been lower over the past 20 years than they were during the 20 years before that, and a bit lower over the past 10 years than they were during the 10 previous. Given that trend, projecting somewhat lower returns for the next decade does not seem unreasonable.

Nonetheless, the gap between expected returns and historical ones, at 2.1 percent, seems high—certainly more than the small decline over the past two decades—raising the possibility that this analysis may be too pessimistic.

Why the gap between expected and historical returns?

In fact, most of the disconnect comes from the drop in expected bond returns. With yields at record lows, the likely elimination of capital gains from bond returns over the next 10 years accounts for much of the gap. For stocks, the gap is smaller, but again, given current valuations, the likely much lower level of capital appreciation makes the difference quite reasonable.

With expected returns lower, we need to think about ways to make up the difference. The good news is, with inflation as low as it is, lower returns will do less damage than they would have in the past.

 

Past 40 years

Past 20 years

Past 10 years

Expected

Portfolio Return

9.67%

6.99%

6.50%

4.4%

Inflation

3.67%

2.18%

1.84%

?

Portfolio Return Less Inflation

6.00%

4.72%

4.66%

?

If you look at general price inflation over those same time periods, most of the differences in nominal returns, before inflation, come from a decline in inflation rather than a change in real returns. One way to look at the current low expected returns is that the market simply expects inflation to remain essentially flat over the next decade or so. If that happens, the effect of those lower returns on what you can actually buy should be much smaller than it seems.

In many ways, this is a reasonable and consistent assumption. Low bond interest rates reflect low inflation expectations, as do low expectations for economic growth and corporate earnings growth. In this light, the news isn’t actually all that bad. This conclusion also starts to point us toward actions we can take to help alleviate any potential problems.

Potential strategies for the problem of low returns

Global diversification. At this point, it’s worth noting a significant limitation in the analysis we have done so far: it has looked only at U.S. assets, and only a subset of them. With the primary problems in generating future returns being slower growth and higher valuations, that limitation gives us a clear signal that perhaps we should be looking to put part of our portfolios outside the U.S. With high valuations in the U.S. constraining returns, and low growth doing the same, it just makes sense to look for faster-growing countries and companies at more reasonable valuations elsewhere in the world.

Bonds and other strategies. There are other ways to approach the problem as well. Bonds that include inflation protection can address one concern. Diversifying the investment strategies you use may be another way to limit your exposure to low returns. There are many approaches to help your portfolio do better than expectations, and the right way will be different for every investor. The key point is that this is a solvable problem.

In order to solve the problem of low returns, you have to:

  1. Be aware of it.
  2. Understand where it comes from
  3. Decide what to do and take action.

Hopefully, over the last several posts, I have demonstrated the first point and at least helped with the second. The third is something you should think about seriously, because the risks are real.

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