Spooked About a Low-Return Environment? Don't Make These Mistakes

A more common viewpoint is that investors are apt to experience muted returns from the stock and bond markets for the next decade

Christine Benz 11 October, 2016 | 16:21
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Few responsible market watchers are predicting that Armageddon is nigh for the stock and bond markets. Instead, a more common viewpoint, from everyone from Vanguard founder Jack Bogle to the folks at Research Affiliates to the researchers at Charles Schwab, is that investors are apt to experience muted returns from the stock and bond markets for the next decade.

In a recent interview, Bogle pointed to simple mathematics to explain his forecasts. For stocks, he combines dividend yield (currently about 2% for the S&P 500) with projected earnings growth, which he expects to be about 5% over the next decade. He then gives that 7% return a haircut of 3 percentage points, to account for the fact that he expects price/earnings multiples--currently at rich levels relative to historic norms--to contract over the next decade, bringing his equity return forecast to just 4%. For bonds, Bogle uses current yields, which have historically been a good predictor of bond returns, for his forecasts; right now, high-quality corporate bond yields are about 2.5%. That translates into a roughly 3.5% return on a 60% equity/40% bond portfolio, and even lower for more conservative portfolio mixes.

As sensibly derived as muted-return forecasts from Bogle and others are, however, the real question is this: What should you do with this information? Forego investing and stash your money in a shoe box? Plow assets that you'd otherwise earmark for plain-vanilla stocks and bonds into alternative asset types, whether precious metals, liquid alternatives, or residential real estate? Indeed, all of this talk about muted returns over the next decade could prompt a host of actions that, in hindsight, prove to be ill-advised. If you've been hearing that you should keep your near-term expectations in check but aren't sure about how that should affect your investment strategy, here are some of the key mistakes to avoid.

Mistake 1: Using Low Expected Returns as a Reason Not to Invest

In the comments below the video in which Bogle shared his return projections, one viewer raises the very reasonable follow-up question: "So why invest at all?" A couple of thoughts. First, Bogle and others are opining on market returns over the next decade, or in some cases, an even shorter time frame. If your portfolio holding period is longer than a decade--and that's the case even for most retirees--the possibility of limited near-term returns of stocks and bonds shouldn't bother you too much. (More on this below.) The second key reason is inflation: Even if a balanced portfolio returns just 3.5% on a nominal basis, that's better than stashing your money in cash in lieu of investing in longer-term securities, where you're almost guaranteed to be a loser even if inflation persists at today's modest levels.

Mistake 2: Extrapolating Muted Return Expectations into Perpetuity

Before you incorporate lower return assumptions into your plan, it's worth remembering that most of the warnings about keeping return expectations in check apply to stock and bond market returns over the next decade or an even shorter period of time. Thus, it's a mistake to apply them to the whole of your longer time horizon--for example, if you have 15 years until retirement and you expect to be retired for 25 years or more. In that case, it's reasonable to give your total return expectations a haircut to account for muted returns over the next decade, but you could reasonably employ return assumptions more in line with historic norms for the later part of your time horizon. While U.S. stocks have historically returned roughly 10% and bonds about 5%, 7%-8% seems reasonable for stocks, and 3%-4% for bonds, assuming a time horizon of 25 or 30 years or more.

Mistake 3: Not Tweaking Your Plan to Account for Them

That's not to suggest lower return expectations shouldn't be a consideration for investors who have long time horizons; they absolutely should be. If you haven't revisited the viability of your retirement plan recently, be sure that you're incorporating reasonable return assumptions such as the ones outlined above. If you're using some type of retirement calculator, you can play around with the various inputs to help reduce the odds of having a shortfall.

Mistake 4: Not Thinking Through Implications for Equity Allocations, Withdrawal Rates if Retirement Is Near

While low expectations for near-term returns shouldn't unduly rattle very long-term investors, those who are getting closer to retirement have reason to pay closer attention. First, equity-market returns rarely move in a straight line; while stocks might end up with low returns over the next decade, they could well trace a volatile trajectory on the way there--steep losses for a few years, better ones after that, and so on. For new retirees, the risk of encountering a market shock early on is a biggie. Retirement researchers find that withdrawing too much from a portfolio that has encountered steep losses in value could permanently impair its sustainability. Thus, if you're a retiree or planning to retire soon, you should revisit your portfolio's equity allocation to help ensure that you're not taking more risk than is necessary. It's also wise to stay flexible on the withdrawal front, as ratcheting down in-retirement spending during weak markets is one of the best ways to blunt the lasting effects of encountering a weak market early in retirement.

In addition to being on guard for equity-market shocks, retirees should also explore the interplay between subpar return expectations for the stock and bond markets and their long-term withdrawal rates, especially if their portfolios tilt heavily toward bonds. As Morningstar Investment Management head of retirement research David Blanchett argued in a research paper with co-authors Wade Pfau and Michael Finke, today's low bond yields, combined with high equity-market valuations, reduce the probability of success for a portfolio plan with 60% in bonds and 40% in stocks and a 4% withdrawal rate. The research suggests that such retirees can improve their odds of success by taking their withdrawal rates to 3% (or even less), steering more toward equities, or being willing to take a more flexible tack toward withdrawals.

 

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About Author

Christine Benz  Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

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