The prolonged economic crisis, weak equity markets and rock-bottom fixed-income returns should cause all who advise individuals on investing to reconsider the assumptions on which much of their advice is based.
The prolonged economic crisis, weak equity markets and rock-bottom fixed-income returns should cause all who advise individuals on investing to reconsider the assumptions on which much of their advice is based.
At least since 1976, when Roger Ibbotson and Rex Sinquefield published their study of the long-term rates of return earned by stocks, bonds and Treasury securities, many, if not most, advisers have assumed that common stocks, on average, would provide an average annual return of about 10% in nominal terms, and a real long-term return of 8%.
Long-term Treasuries, on the other hand, could be expected to provide a real return of between 2% and 3% per year.
Given the current situation, these assumptions must be re-examined, especially since weak economic growth is forecast for the foreseeable future.
History would suggest that equity returns are likely to be below average for some time, perhaps even decades.
For the two decades after the stock market collapse of 1929 and the Great Depression, the stock market languished, producing real annual returns of just 5.6%. Could it do so again after the recent Great Recession?
In 2002, Robert D. Arnott, chairman of Research Affiliates LLC, and the late Peter L. Bernstein won the Graham and Dodd Award for excellence in financial writing for a paper in which they argued that equity risk premiums — the returns paid by stocks over the returns of risk-free assets such as Treasuries — were too high, and could not be sustained long-term.
At about the same time, Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School reached similar conclusions in their book “The Triumph of the Optimists.”
Unfortunately, all of these distinguished authors and thinkers were six years too early with their warnings; few heeded them.
Prudent financial and investment advisers will use the financial crisis to look at the analyses by these authors and consider the possibility that they were right.
What is a realistic rate of economic growth for the United States over the next two decades? If slow economic growth persists, what then is a realistic real return on common stocks for the next 10 to 20 years? What if the nominal rate is 8% instead of 10%, and the real rate is 5% instead of 8%?
Given the low level of interest rates, what is likely to be the long-term return on fixed-income portfolios? When interest rates next move up, the return on bonds will be negative, and that could last for years, especially if inflation develops and persists.
If the best choice is neither stocks nor bonds, are there investment alternatives that individual investors can use to diversify their portfolios or to enhance their long-term returns? While the very richest may be able to invest in exclusive vehicles that attempt to reap higher returns or promise lower volatility, what of the average investor saving for retirement? What does he or she use?
The answers to these questions have significant implications for everyone.
If expectations for returns are unrealistically high, investors may have to pull in their belts today to save more for their retirement or accept a less satisfactory lifestyle in retirement.
With so much riding on investment returns, prudent advisers should be taking a new and in-depth look at their return assumptions.
