Despite two steep stock market declines in the last 15 years, baby boomers that 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 7percent 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, experience shapes our future outlook. In other words in the context of the financial markets, “the good times should continue to roll”. That perspective, however, does not 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. 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 do not 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. In basic terms, the more optimistic the return assumption, the less we need to save to accumulate a desired amount of money. Conversely, the more conservative the assumption, the more we will 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 2.5 percent, so this would be a reasonable return to expect for the next ten 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 2.5 percent, we arrive at real returns close to zero for bonds and about 3.5 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 just over 4 percent before inflation and 2% 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 investors are 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.
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.
Spoto is the founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com