A major concern of investors worldwide is the expectation for low returns for the foreseeable future. The consensus among economists, academics and other investment experts is that today’s low interest rate environment does not bode well for either future bond or stock returns. Furthermore, based on these same estimates, it appears unlikely that this situation will reverse itself anytime soon.
Although forecasting interest rates and stock returns is notoriously difficult, and essentially impossible in the short term, when reasonable metrics are applied to the fundamental components of investment returns including current interest rates on bonds, dividends paid on stocks and inflation expectations, we can arrive at reasonable estimates for the future. As I discussed in a recent article, a portfolio consisting of 50 percent bonds and 50 percent stocks can be expected to return about 5 percent before inflation and 2 percent in real (after inflation) terms.
Most investors, whether institutional (e.g. pension fund, insurance company, etc.) or individual (e.g. worker or retiree), share a common objective: to fund future goals. Establishing reasonable return projections is an essential part of determining how much an investor should spend, save and invest in order to achieve those goals.
In simple terms, if projections are overly optimistic, investors will spend too much, save too little and fall short of achieving important goals, such as building a retirement nest egg or in the case of those already retired, preserving that nest egg throughout retirement. Conversely, using overly pessimistic returns forces investors to be unnecessarily frugal, save more than necessary and deprive themselves of a lifestyle they could otherwise afford.
The prospect of low returns creates enormous challenges and imposes additional stress on investors. They not only need to control spending but also to build and manage portfolios that are consistent with the amount of risk that they can tolerate while offering returns sufficient to reach important goals. So what can investors do now to prepare for a future where investment returns are likely to be less robust than what we have become accustomed to?
Not surprisingly, many financial institutions and their representatives offer remedies for this unpleasant problem by using a variety of “alternative” approaches. The promise of higher prospective returns is alluring; unfortunately many of the “solutions” proposed are based more on wishful thinking rather than common sense and time-tested investment principles. They include increasing allocations to equities, using higher risk alternative investments, and employing leverage and complex derivatives.
In short, these strategies simply increase the risk of the portfolio in exchange for the chance to earn expected but uncertain higher returns. With the higher risk, the investor is accepting bigger losses in bad times, a trade-off that most investors will wish they had not made, when, and not if those bad times arise. Unfortunately, many investors have been slow to accept this inconvenient reality.
Finally, these are the same products that have been pitched to investors for years, only in different “wrappers’ and with more scientific sounding names. If investors applied the rule “don’t buy it unless you understand it,” the sales of these products would fall precipitously.
Investors have reason to be concerned. However, the smart ones who accept the fact that future returns are likely to be less than half of the historic averages will still find effective ways to build and preserve their portfolios and achieve their goals. They will do this in large part by accepting only the risk they can tolerate, identifying the major drivers of investment earnings and focusing their efforts on those factors they can control.
While no one can control or predict what interest rates, inflation or investment returns will be, successful investors can and do control how much they spend and save and how much of their investment earnings they lose to expenses and taxes. They know it’s not how much you earn that counts. It’s how much you get to keep.
John Spoto is the founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com.
This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions.