A Few Words on Expected Returns

Cheri Franklin |

For the purpose of financial planning, it is necessary to have a projection of future expected returns and risks of the major asset classes.

I want to state at the outset that I am no fan of forecasting, especially of something so uncertain as future returns. If there is one thing I learned from my 18-year career as an actuary at a large insurance company, it’s that forecasting future profits is a fool’s errand. One of the components of projected profits was the return on the assets held to back the insurance liabilities, mostly bonds and mortgage-backed securities. The default assumption was a constant future rate of return based on current bond yields and recent historical returns. Naturally, we tested a few scenarios, including a 3% drop in interest rates, but never in our wildest dreams did we anticipate a 1.75% yield on the 10-year Treasury bond. This explains why many insurers are currently dwelling in Jim Cramer’s House of Pain with no end in sight. It also explains why you would be dwelling on Fantasy Island if you really expect your stock portfolio to deliver the long-term historical return of 10% while Treasury bond investors have agreed to settle for less than 2%.

Regardless of how much I despise forecasting future returns, I have to begrudgingly acknowledge the necessity of it when creating a long-term financial plan. The key term here is “long-term”, as it is essentially impossible to accurately forecast short-term returns, so all the numbers presented henceforth are for the next 10 to 30 years, with one notable exception.

While I could talk about valuation measures such as the Shiller cyclically-adjusted price-to-earnings ratio, or I could drone on about dividend yields and projected growth rates, I find it more useful to review the projections of experts whom I respect. Let’s begin with Bill McNabb, CEO of the Vanguard Group, who says in Bloomberg BusinessWeek that bonds—including higher-yielding corporate debt are likely to average 2 to 3 percent over the coming decade. A combined global and U.S. stock portfolio might earn about 7%. He offers up a bitter pill for investors when he says, “Over the next 10 years, the markets aren’t going to bail you out if you haven’t saved enough.” John Bogle, McNabb’s predecessor and founder of Vanguard, is even more pessimistic for stocks at 6% for the next decade. This lines up with Charles Schwab’s forecast of 6.3% for the S&P 500 Index.

To be clear, there are some forecasts out there that I dismiss as ridiculously pessimistic such as GMO’s negative 2.1% real (inflation-adjusted) returns for the next seven years. At Clarity, one of our core beliefs is that markets work and assets are priced to compensate buyers for the risk they accept, and given their risk, there is no reason to ever assume that equities have a zero or negative expected return. This is also why I cannot endorse Research Affiliates’ forecast that shows equal 1.1% real (inflation-adjusted) returns for stocks and bonds.

Even though I have been critical of Morningstar’s star-based rating system, I have to acknowledge that they have no shortage of highly talented people on staff. One of them is Josh Peters, Director of Equity-Income Strategy who forecasts 6-7% returns for the S&P 500 over the next few decades. A more official number comes from Morningstar Investment Management which forecasts a 4.5% stock and 2.6% U.S. bond return for the next decade. Ouch!

I will end this article by citing one of my favorite financial writers, Jason Zweig of the Wall Street Journal. In “The New Era of Low Stock Returns” on 3/27/2015, he presents an analysis from one of the greatest intellects in our business, William Bernstein, which concludes that a balanced portfolio of stocks and bonds can expect about 2% after inflation and taxes. Zweig offers his usual sage advice when he says, “You aren’t entitled to higher returns just because you feel you need (or deserve) them. If traditional investments deliver paltry returns, that doesn’t ensure that ‘alternatives’ like hedge funds, complex trading techniques or esoteric bond funds will do any better. Take extra risk in a low-return world and you are likely to reap the risk without earning the reward.” I couldn’t agree more.