I ended my last blog by referencing an interesting study that demonstrated we humans tend to err on the side of optimism in our lives. Generally, a positive outlook is good for you. It’s probably helped many parents raise their teenaged children to adulthood, for example, without changing the locks on them even once.
But when it comes to expected returns on your investments, it’s best to be as realistic as possible. “The faith in fancifully high returns isn’t just a harmless fairytale,” says Wall Street Journal columnist Jason Zweig in a recent article exploring what financial experts had to say on the subject of market returns. He examined the expectations of trustee-level investors, economic professors, seasoned investment advisors and fellow financial journalists, and received opinions on hoped-for long-term market returns (after inflation, expenses and taxes) ranging from an anemic 0.5 percent per year to a feverish 22 percent per year.
Overall, the data suggest that most investors’ expectations are too high. Way too high. Zweig cited a 2009 nationwide survey that indicated investors were expecting annual U.S. market returns of 13.7 percent during the next 10 years. He quipped, “What are we smoking, and when will we stop?”
OK, then what sort of long-term return expectations would be realistic for stocks? Lacking a crystal ball, single digits seem a far more prudent assumption than anything even close to double-digits — especially if inflation stays as low as it is now.
Here’s why. According to financial economics, stock returns are driven by the “equity premium,” which is the amount stocks earn above the risk-free rate of one-month Treasury bills. The risk-free rate, in turn, is the rate earned above inflation. Translating that into a simple equation, it looks approximately like this:
Rate of Inflation + Risk-Free Rate + Equity Premium =
Expected Stock Returns
So what numbers do we plug in? As described above, current inflation rates are around 2.7 percent. Historically, the risk-free rate has earned about 0.7 percent. (It’s a relatively small return, precisely because it’s essentially risk-free.) Conservatively, the equity premium has hovered at around 4.8 percent over long time periods. So plugging in these numbers:
2.7 percent + 0.7 percent + 4.8 percent = 8.2 percent
Will your expected returns be exactly 8.2 percent? Of course not. For one, the math is based on historical returns, and nobody can predict the future so accurately. In addition, most investors temper their equity investments with fixed income, which offers a more stable ride, but also lowers expected returns.
The point is, particularly if inflation stays so low, the average rate of return on stocks over the next 20 years won’t be anywhere near 22 percent. It probably won’t approach the average U.S. investor’s expectation of 13.7 percent over the next decade, either.
Does 8.2 percent sound low to you? If so, consider that this is 5.5 percent more than the current 2.7 percent rate of inflation. That means, with a long-term, compounded rate of return of 8.2 percent for the equity portion of your portfolio, you should still be able to beat inflation by quite a lot and build real wealth through appropriate portfolio construction strategies. In future blogs, I’ll cover some of these techniques.