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Spooked about a low-return environment? Don't make these mistakes

Christine Benz  |  13 Oct 2016Text size  Decrease  Increase  |  
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Low return forecasts aren't a reason to skip investing but they do have an impact on saving and withdrawal rates and asset allocation. From Morningstar US.


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 US 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 per cent for the S&P 500) with projected earnings growth, which he expects to be about 5 per cent over the next decade.

He then gives that 7 per cent 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 per cent.

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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 per cent.

That translates into a roughly 3.5 per cent return on a 60 per cent equity/40 per cent 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?

Or attempt a tactical trading strategy in an effort to eke out a higher return?

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 per cent 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 US stocks have historically returned roughly 10 per cent and bonds about 5 per cent, 7 per cent to 8 per cent seems reasonable for stocks, and 3 per cent to 4 per cent 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.

Of course, the most obvious way to improve the odds of success despite the headwinds of a low-return environment is to increase your investment contributions; even small additional contributions can help bridge the gap between a low-return environment and a more normal one.

(Flicking on the "automatic escalation" feature in your company retirement plan is one of the most painless ways to kick in more on a regular basis.)

Investors can also improve their take-home returns by watching the cost side of the ledger, as limiting tax and investment costs can help ensure you take home the highest possible percentage of a slimmed-down return.

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 call it "sequence of return risk," which simply means 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 you're not taking more risk than is necessary, as discussed in this article.

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.

(Of course, that's easier said than done, but ideally your in-retirement budget would allow for some wiggle room--higher spending in some years, belt-tightening in others.)

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 this 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 per cent in bonds and 40 per cent in stocks and a 4 per cent withdrawal rate.

The research suggests that such retirees can improve their odds of success by taking their withdrawal rates to 3 per cent (or even less), steering more toward equities, or being willing to take a more flexible tack toward withdrawals.

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Christine Benz is Morningstar's US-based director of personal finance.

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