Wednesday, November 11, 2015

'Required' vs. 'Expected' Return on Investments ... Low Growth, Low Interest Rates and Low Inflation Will Mean Lower Investment Returns ... Here's My Plan

Stocks have returned ~10% annually (nominally) over the past several decades. However, that's not going to be the case going forward. In 'real' money, annual stock returns have approximated 6%, and that, or something close to that, should continue to be the case over time. At least that's my guesstimate.

Real money is the key. And over the long haul, real gains which outpace 'less risky' investments in such 'safe' assets as bonds, CDs, gold and real estate are best achieved by investing in blue chip stocks. For the foreseeable future, low economic growth and low inflation will mean continuing low interest rates. In turn this will translate to lower nominal investment returns relative to the historical results which occurred during prior periods of higher economic growth and higher inflation.

But that's not necessarily a bad deal, and it's definitely not something individual investors can control. For long term focused savers and investors, it's the comparison with other potential investment choices that matters most in seeking to generate satisfactory real inflation adjusted returns.

Why Investors Need to Understand 'Required' Returns vs. 'Expected' Returns offers this valuable advice for properly planning and investing for the future:

"Over the past 90 years, the stock market has returned about 10% annually. Of course, the returns have been quite different over different time periods within that 90-year period.  So what are the expected returns for the market going forward?

It makes no sense trying to predict what the returns will be over the next year, or any intermediate time period, as returns over short time horizons are volatile and probably more driven by short-term shocks than longer term fundamentals.  So how about the next 10 years?

Recall the aftermath of the global financial crisis.  In 2009, the general wisdom was that the economy was going to grow very slowly for the foreseeable future, and, accordingly, earnings would be lower and would grow at a much slower pace.  And, therefore, stock-market returns would be modest, at best. . . .

The reality is that gross domestic product (GDP) has, indeed, grown at an anemic pace, but earnings have, for the most part picked up where they left off.  According to data from Robert Schiller at Yale University, during the time period from 1960 to 2007, normalized earnings of the S&P 500 index grew at a 6.5% pace per year.  From 2008 through June, 2015, earnings grew 5.1%–a bit less than the prior period, but certainly not enough to justify a pessimistic view of the market.  Of course, the stock market, as measured by the Vanguard Total Stock Market Index Fund, has soared since the end of the bear market—up 18.6% annualized from March, 2009 through September, 2015.

In reality, the market will return what investors require, not what they incorrectly expect.  There are two major drivers of investors’ required returns—the perceived level of risk of the investment and alternative investment opportunities.  Since most rational investors are risk averse, if there are two potential investments with the same expected return, but one is presumed to be riskier, then no one will invest in the riskier of the two.  In order for the riskier investment to attract capital, it will have to provide a higher return.  And the level of that return will be a spread relative to other investment opportunities.  If the returns of other investments are meager, then the required return of the riskier investment will be less than if those other investments provided robust returns.

So we should not talk about the expected return of stocks.  We should talk about the required return.  And, to reiterate, that required return is a function of the perceived risk and other investment opportunities.

Thinking back to 2009 and 2010, the perception was that the stock market was extremely risky.  After all, we had experienced two pullbacks of around 50% in eight years.  At the same time, interest rates were a bit lower than historical averages, but certainly much higher than today.  So the returns from bonds were OK, but the perceived risk of the stock market was through the roof.  Therefore, the required return was extremely high.  After all, who would invest money in the stock market if they were going to earn the average historic return?  And, as mentioned above, the market has, in fact, provided this high required return over the past 6 1/2 years.

So what do investors require today?

The answer is in the current perception of risk and alternative investment returns.  Although market commentators might try to whip you into a froth over current market volatility, the reality is that the market today is probably exhibiting the historic level of risk, and even arguably less.  At the same time, investment opportunities from bonds and cash are, quite simply, paltry.  So, average to slightly lower risk, and unattractive alternative investment returns means that returns from the stock market over the next decade are likely to be significantly less than the 10% historic return.

I won’t try to predict how much less.  That’s a fool’s errand.  However, investors who are creating their expectations around historic returns, of, say, 7% to 8% from a balanced portfolio, are likely to be very disappointed."

Summing Up

An all equity approach to investing will be the winner going forward, just as it has been historically. See Why 100% of your investment portfolio should be in stocks.

As interest rates rise slowly and remain low by historical standards, bonds will be lucky to yield an average annual nominal return of 2% over the next decade and actual nominal returns may be zero or even negative. {NOTE: That's because the value of the outstanding bonds will decrease as interest rates rise.}

Assuming that stocks (dividends and share price growth combined) earn ~7% to ~8% and that bonds earn 2% annually over the next ten years, a balanced or blended portfolio of stocks and bonds will probably return ~5% nominally on average, or 3% in real money.

So here's the deal for long term focused individual savers and investors: an all stocks approach is the optimal way to achieve after inflation returns comparable to those realized in prior periods of higher inflation, higher interest rates and higher economic growth.

That's my guesstimate, that's my plan and that's my take.

Thanks. Bob.

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