Revisiting Return Expectations

Updated: Sep 8, 2021

"Low rates makes risk-aversion a challenging thing to practice and risk-taking much more palatable." - Howard Marks, Oaktree Capital

Experts have been sounding the alarm over lower future returns for the better part of a decade. Low interest rates plus higher U.S. equity valuations had to equal muted returns going forward.

The S&P 500 pulled a Lee Corso, ESPN's popular College Game Day host, "not so fast my friend!," and proceeded to do this:

Source: Ycharts

The above graph shows the S&P 500 over the past 10 years (as of 10/14/2020). The index returned a shade under 14% per year, defying even the most optimistic forecasts. The historical average return of the S&P 500 is ~ 8% (post 1957 when the index went to 500 stocks).

Much has changed since we wrote about "Delusional Return Expectations," back in 2017. Realized equity returns made the expectations a bit less delusional (the exception being millennials, which expected 20+% annualized returns). The risk-free rate is basically zero, stocks have recovered and are near all-time highs, earnings guidance is non-existent, and U.S. GDP has taken some wild quarter to quarter swings.

Working off of that base, what are realistic return assumptions going forward?

According to GMO, there's not much to be excited about, unless you're into emerging markets, especially EM value stocks...

Source: GMO Research

The above graphic shows annualized real (after inflation) return estimates for the next seven years. These are professional guesses, but the GMO researchers do not share optimism for U.S. assets, either stocks or bonds.

Starting with the low-hanging fruit, bond future returns have historically tracked the current starting yield. Therefore, we can state with some confidence that fixed income returns going forward should be lower. This makes sense because the income portion is significantly reduced due to the low starting yield.

However, given that the risk-free rate is the starting point for other asset returns, it's not a stretch to assume all assets could see lower future returns.

Here's a graph from Howard Marks' latest memo on how the bottoming out of the risk-free rate affects other asset return profiles:

Source: Howard Marks, Oaktree Capital

The above graph shows a downward shift in various asset class return expectations. Notice how the returns are lower across the board, but the risk for each asset class remains the same. Investors are being asked to receive a lower return, while still taking the same risk. Not an ideal set-up.

The "lower future return" conversation isn't very fun, especially coming off the heels of a golden decade (2010s). A few things to keep in mind...

Forecasting future returns is hard, especially for equities. Most experts have been wrong for the better part of a decade.

Forecasting real returns is even harder. You have to get two things correct: asset class returns and inflation. Our own government provides a perfect example of how difficult the latter is...

The above graph shows the Congressional Budget Office's prediction for the U.S. 10-Year Treasury yield. Every year the government wildly overshoots. Why? Because inflation is almost impossible to predict.

Here's are some things to consider:

  • The return assumption within a financial plan should be conservative. I would hesitate to use anything above 5%.

  • Find your "enough." Assume returns are paltry going forward. Build a margin of safety into your financial plan.

  • Many are allocating a greater percentage to equities to hit return bogeys. Here are some lessons from our Japanese friends who have been investing in a 0% world for almost 30 years.

  • Low yields have changed the fixed income landscape making it tough on savers to generate income. Here are some guidelines for generating income in a challenging environment.

  • Quit paying 1%+ to traditional advisors. Quit allocating to mutual funds, especially fixed income. If future returns are lower, can you really punt half of the return to fees and expenses? Find out if your advisor is a professional or amateur here.

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