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September 15, 2013

It's what you keep that counts

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?

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