Following up on Gary’s Tacoma News Tribune column on February 2, here’s another way to look at expected investment returns.
Portfolio construction principles start with what is perceived to be the “risk-free return.”
In order to take a step up the risk ladder, investors need to be rewarded with more return than the risk-free asset. This return above the risk-free asset is called the equity risk premium. The historical equity risk premium for broad stock markets has generally been considered to be 4.5-6.0% per year. It used to be that the 10-year Treasury bond paid 4%. If you start at 4% and added 4.5-6.0% of equity risk premium, you could reasonably expect 8.5-10% returns on stocks, in line with historical averages.
Today, the return expectation has been squeezed from both ends. Currently, 10-year Treasuries pay approximately 2%. A recent survey by the Chartered Financial Analyst (CFA) Institute of prominent money managers suggested that the equity risk premium is now in the 3.5-4.0% range. So you add the two together and now you’ve got expected returns of the broad stock market at 5.5-6.0% per year. Oddly, at a time when risk seems more prominent, and therefore should command an even greater premium to take on the risk, prudent expectations for returns have declined considerably.
You could conclude that if stocks aren’t expected to reward you at the historical rate, why bother to take the risk? Instead, you could just focus on bonds. The problem is that bonds, especially in the U.S. seem less attractive than stocks on a risk-adjusted basis.
For many years, a common assumption of investors has been that with a broadly diversified mix of stocks and bonds, you should be able to double your money every 10 years. This rule of thumb requires an average annual return of 7.2%, assuming no withdrawals. Therefore, if returns are reduced, the double-your-money formula takes longer. At 6% returns, it takes 12 years to double. At 5% returns – assuming that some bonds have lessened the overall return expectation for a balanced portfolio – it’s closer to 14.5 years to double.
For someone who is still working and saving, there is opportunity to save more or work longer to overcome these lower expected returns. The big problem confronts current retirees who are withdrawing money to supplement their income. Lower returns on their remaining invested capital mean that even the “safe” withdrawal rate of 4% could be too high to guard against exceptional longevity or unexpectedly high expenses.
Ideally, over time, global debt and economic challenges will improve and expected returns will revert to more normal levels. But investment performance can be fleeting. That’s why it’s important to have an understanding of “what if?” as part of your retirement income plan.
~ Brooks, Hughes & Jones, Partners in Wealth Management, Tacoma, WA