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September 8, 2013

Getting real about investment returns

Despite two steep stock market declines in the last 13 years, baby boomers who are now retiring in droves have grown accustomed to earning strong returns on their savings and investments. Over the last 30 years the stock and bond markets returned roughly 10 percent and 6 percent respectively before inflation and about 7 percent and 3 percent in real (after inflation) terms.

Although we are repeatedly cautioned that “past performance does not guarantee future results,” research in the field of behavioral finance has demonstrated that even for sophisticated investors, past experience shapes our outlook of the future. In other words, in the context of the financial markets, “the good times should continue to roll.” That perspective, however, doesn’t square with the realities of today’s investing environment.

Investors worldwide are still grappling with the effects of the deepest economic downturn since the Great Depression. In an effort to stimulate the economy the Federal Reserve and central banks around the world embarked on an aggressive strategy to drive down interest rates to near historic levels.

The result is that we have transitioned to a world of low interest rates that most experts anticipate will continue for the foreseeable future. This presents a challenge for investors seeking to preserve and grow their nest eggs for two reasons.

First, with bonds generating miniscule yields, extrapolating the high bond returns of the last 30 years into the future would be pure fantasy. Second, because both history and basic financial principles teach us that equity returns are affected by interest rates; low rates also have important implications for stock returns.

The dilemma faced by every investor from institutional fund managers to average individuals is that projecting future investment returns with certainty is unrealistic because we don’t know precisely how the future will unfold.

However, in order to make intelligent decisions including how much to allocate to the different asset classes, how much we can spend today, and how much we need to save to fund future goals, we need a projection of the markets’ long-term performance.

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