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September 8, 2013

Getting real about investment returns

(Continued)

In basic terms, the more optimistic the return assumption, the less we need to save in order to accumulate a desired amount of money.

Conversely the more conservative the assumption the more we’ll need to set aside to reach that goal. So, how do we construct reasonable return expectations for U.S. bonds and stocks going forward? Fortunately we have guidelines that have proven helpful in the past, particularly for bond returns, and from these we can estimate equity returns.

Since most of the returns that bond investors earn come from the yield (the interest the bond is paying), a good predictor of future bond returns is the current yield. A 10-year Treasury bond currently offers a yield of about 3 percent, so this would be a reasonable return to expect for the next 10 years.

Although stock returns are unpredictable in the short-run, when investment experts apply metrics that have demonstrated predictive value in the past including the relationship between stock market returns and U.S. government bonds, expected long-term stock returns hover around 6 percent

When we adjust for a projected inflation rate of about 2 percent, we arrive at real returns close to zero for bonds and about 3 to 4 percent for stocks. To carry out the arithmetic further, this means an investor with a portfolio of 50 percent stocks and 50 percent bonds should be targeting an overall assumed return of about 5 percent before inflation and 2 percent after inflation. In other words, less than half the return we have enjoyed historically.

This means that many of the return assumptions built into the financial plans of individual investorsare overly optimistic. This may result in large funding shortfalls posing serious problems, especially for those trying to determine how much to save for retirement and once in retirement how much to spend without running out of money prematurely

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