Average Annual Investment Returns ... For Long Term Investors, IT'S THE PURCHASING POWER, STUPID! ... Changing Investment Landscape Requires More Stocks and No Bonds

Over a long period of time, nominal investment returns on a basket of stocks have averaged 10% annually. In inflation adjusted terms, annual gains have averaged 7%.

Roughly 3% inflation plus a 7% real return on stocks makes up the 10%. {Please remember these are generally correct but rough numbers.}

In real terms, money market funds and CDs have earned 0, bonds have earned 3% (~6% nominal total return on interest and appreciation combined) and stocks have earned 7%, or 4% in excess of bonds annually. That's important to remember when contemplating our individual future portfolio and asset mix in 401(k)s and such.

Of course, a 10% annual return on stocks hasn't been the case in the past decade or so. Much less, in fact. So what should individual investors expect in the future?

Well, in inflation adjusted returns, it will be nearly impossible to expect to break even on cash or bonds at least until the end of this decade. With respect to both cash equivalents and bonds, interest rates now are at historic lows, so investors will be lucky indeed to earn the coupon (stated interest) rate, let alone realize any capital gains on bonds for the foreseeable future.

While we don't know precisely when rates will rise appreciably (2016?), we do know they have virtually no more room to fall. But when the economy eventually strengthens or inflation rears its ugly head, rates will certainly rise. Cash equivalents and bonds will not be the place for long term individual investors the next few decades.

Since bonds and cash will almost certainly earn less than the inflation rate in the foreseeable future, that leaves stocks as the last one standing to preserve and increase purchasing power.

And therein lies a happy possibility for those willing to chart their own course. Thus, let's talk about what individual investors should do.

But first, let's ask the following question: Can we reasonably rely upon realizing an annualized 7% real rate of return on stocks in the future? And the answer is ----- probably not.

We can, however, expect something very close to that and much better than cash and bond alternatives.

And when these estimated 5%-7% real returns on stocks are combined with altering our modified investment mix from 50/50 stocks to bonds to all stocks, we'll beat the results of the past for our newly modified investment portfolio.

To repeat, the typical investment mix in the past for individuals of 50/50 bonds to stocks with a real return of 3% for bonds and 7% for stocks would have yielded an overall 5% overall in real terms. And in the future, stocks in real terms should outperform that 5% total rate of return.

Thus, what we have to do is convince ourselves to switch to a full portfolio of stocks for the long term. And for the average investor, that will take some convincing. So let's get started.

As a caveat, let's acknowledge that it's difficult to make accurate predictions, especially about the future. On the other hand, however, Patrick Henry once said this, "I know of no way of judging the future but by the past."

But that said, we don't have to be "overly optimistic" about the future. For the sake of argument, let's agree that's 7% in real terms on stocks may be too high and opt for a lower rate of return assumption. Maybe 5% or 6%.

Accordingly, we'll still be able to improve on the old total portfolio returns by switching one half of our portfolio from bonds to stocks. While that's a mouthful, it makes sense, at least to me.

Kiss 10% market returns goodbye is subtitled 'A growing number of experts say investors should no longer expect the double-digit returns of the past:

". . . many market experts say the kinds of historic returns they’ve come to expect are gone for the foreseeable future.

Ask most investors what they expect to get from the stock market and the answer is typically 10%. That’s a homage to an old study by Roger Ibbotson and Rex Sinquefeld that showed several generations of investors that stocks average that level of return — albeit before any transaction costs — over time.

No matter how much the market has bounced around — through periods where a 10% return lagged behind the overall market badly and downturns when a double-digit gain felt like a fairy tale — investors have had the sense that if they can stick with the market long enough, they will come away with that 10% gain.

The problem is that the experts, including Ibbotson himself, don’t believe it.

“Starting in 1926, the return on the large-cap market has been 9.8%, but this was during a period when inflation rates are higher than they are today, and risk-less rates were higher than they are today,” said Ibbotson, a Yale professor who also currently serves as chairman and chief investment officer at Zebra Capital Management. “You have to knock it all down by a couple of percent, because we really are in a risk-less rate environment where the rates are close to zero.”

For the next quarter-century or more, Ibbotson said he would “not predict more than an 8% return on the market, but that’s not bad. That’s a great return.”

Likewise, Vanguard Group founder Jack Bogle . . . said the current market . . . is going to deliver smaller returns than what experienced, adult investors have in their heads. He pegged the return in the 6% to 8% range for stocks going forward, also citing low yields and low inflation as key reasons to alter long-term expectations.

Of course, a lot of investors would be thrilled to get 8% from the market these days, a far sight better than the returns they have earned over the last decade. But if history has not been suspended — and the experts don’t think it has been, they just believe returns will be lower — the lowered expectations do significantly change long-term financial and investment planning.

Consider someone who starts investing in their 20s and has a long life ahead of them. A 10% market return would double their market return every 7.2 years, compared with a 9-year time frame when the return is just 8%. . . .

The challenge is that inflation is still in the 2% to 3% range, and investors can’t get to where they want to be with a less than 2% Treasury bond, combined with a 6% to 8% stock market, said Jeffrey Coons, president of the mutual fund firm Manning & Napier. “You combine those together and you never really get to those numbers you use in your retirement calculators, or that a pension plan would use for its actuarial assumptions. Those absolute returns really are the issue.”

Aside from changing the assumptions they plug into those calculators — a move that makes the ultimate outcomes look significantly more bleak and doubtful — experts are split over what investors should do as a response to this less fruitful environment.

Average long-term investors have always tried to capture the long-term trends; it’s why low-cost indexing has delivered so strongly over time. . . .

“We’ve been talking about these lower returns for a few years now,” Ibbotson said, noting that the stock market’s volatility and lack of strong returns over a decade has scared off a lot of investors. 

“But I don’t know that most people have responded. They haven’t changed their expectations, or increased their savings or tried to figure out if they will really have enough if the market isn’t as good over the next 25 years as it was for the last 75.

“One way or another, however, I think most people have to change their behavior, change their equation. That’s the only way this turns out over the coming decades the way people expect and hope for.”"

Summing Up

Stay with stocks.

As long as interest rates remain low, stocks will outperform both cash and bonds.  And even after interest rates rise, which they eventually will, stocks will still beat both cash and bonds by a very wide margin during a period of rising rates.

Over any 30 year period, stocks have always outperformed bonds. And for the next 30 years, it's a no brainer.

In fact, the next three decades will be the exact opposite of the past 30 years when rates continuously declined. That's why stocks over bonds will be a no brainer.

And stay with DIY directed low cost index funds, too. Like the S&P 500 Equity fund offerings from either Vanguard or Fidelity.

It's the best way for individuals to invest for the long haul.

At least that's my view.

Thanks. Bob.