Q: I read some projections that showed the returns of stocks and bonds would be very low over the next decade. What should I do differently with my investments because of that?
A: Every year there are several papers published that project future returns. The most recent paper from investing behemoth Vanguard estimated annualized, nominal (before inflation) returns of just 3.3 percent for U.S. stocks, 2.9 percent for U.S. Real Estate Investment Trusts (REITs), 6.2 percent for international stocks, and 1.9 percent for US bonds.
The first thing to know about these papers is that they are often wrong. For example, over the last decade many of these papers have called for much lower returns than what markets have actually experienced. It turns out that everybody’s crystal ball is cloudy, not just yours. While valuations such as price to earnings ratios and bond yields do matter, they are pretty lousy predictors of future returns, especially in the short-term. These projections also tend to be on the pessimistic side for an obvious reason. As an investment professional making projections, if markets do better than your projections, none of your clients are mad at you. But if you call for high returns and they don’t show up, the clients all take their business elsewhere. So, take any future expected return projections with a grain of salt.
These projections are also overly precise. They are reported to a tenth of a percentage point, but there is an extremely good chance they don’t have the first number right, much less the second. In reality, any projection that is not a range is improperly precise. While that precision makes the projectors look smart, it is inappropriate given the difficulty of the task. Unfortunately, a proper projection would have such a wide range as to be almost useless.
However, I actually agree with the projectionists that investment returns over the next decade are likely to be significantly lower than those over the last decade. This occurrence would have significant consequences on your financial life. What should you do about it? Several things.
- Reduce the Bite of Taxes, Fees, and Inflation: The only return that matters is your after-tax, after-fee, after-inflation return. Reduce your investment related taxes by maximizing the use of tax-protected retirement accounts like 401(k)s, Roth IRAs, Health Savings Accounts (HSAs), and 529s. Avoid short-term, rapid-fire trading so you can take advantage of lower long-term capital gains and qualified dividend tax rates. Watch your investment commissions and advisory fees. Every dollar you pay to someone else is a dollar that comes out of your investment return. You also want a significant portion of your portfolio invested into assets that tend to keep up with or beat inflation in the long run such as stocks, real estate, and inflation-indexed bonds.
- Stay the Course: Following a written investing plan through thick and thin is a key to successful long-term investing. Chasing performance by jumping from one type of investment (asset class) to another leads to higher costs and lower returns as the investor repeatedly buys high and sells low. As a general rule, in a low interest rate and low expected return environment, all asset classes are affected more or less equally. While bond yields are particularly easy to see, the truth is that when bond yields (and thus future bond returns) are lower than historical averages, so are the returns of everything else including stocks, real estate, and speculative investments. Expecting low bond yields due to low interest rates while also expecting historical stock returns is a classic error.
- Do Not Fear Rising Interest Rates: Investors, particularly bond investors, have an inappropriate fear of rising interest rates. While rising interest rates do decrease the value of bonds (as well as stocks), this is only a short-term effect. In the long run, a bond investor does better with higher interest rates, so long as the investor’s investment horizon is longer than the duration (a measure related to the maturity length) of the bonds. All else being equal, higher interest rates are better for savers and investors (although worse for future debtors).
- Diversify: Recognize that just about every asset class will have its day in the sun. That is not an invitation to jump from asset class to asset class, chasing performance. Instead, make sure you own several asset classes in your portfolio. Diversification is key. The Vanguard projections suggest higher future returns for international, small, and value stocks than for the U.S., large, and growth stocks that have outperformed in the last decade. Make sure your portfolio includes some of those asset classes.
- Be Philosophical: Rather than being depressed that future returns are likely to be lower, try to be a bit more philosophical. Recognize that if past returns had not been so high (leaving more room for future growth), your nest egg would be much smaller. Higher returns on a smaller nest egg are not all that different from lower returns on a larger nest egg for most investors, although very old and very young investors will obviously prefer opposite ends of that spectrum.
- Save More: You cannot control future returns. You might as well accept the returns the market gives you and spend your effort controlling that which is within your control, such as your lifestyle and thus savings rate. If future returns are really lower, then you will need to save more money to reach your goals. Future returns, especially after inflation returns, are likely to be lower than in recent decades. You should still follow your reasonable, written investing plan. If you do not yet have one, develop one, either with or without the assistance of a capable financial planner.