Investors that once thought 10% annual returns were a birthright are now forced to contemplate the prospect of reduced returns going forward. While many investors have been fearful of lower returns for years, those fears have largely failed to materialize.
Granted, diversified portfolios that included investments in non-U.S. stocks, emerging market stocks or almost any alternative investment have had modest returns the past three years. However, few U.S. investors have experienced an acute reduction in their total return for any length of time since the end of the Great Recession.
In a world with interest rates anchored near zero, the problem of anemic future returns has been widely discussed among fixed income investors. The plight caused by low interest rates has been magnified by the fact that today’s generation of investors relying on bonds for spendable income can easily recall when bond yields exceeded 10% in the 1980s and total returns from the 1990s and 2000s were still generating high-single digit results.
Today, the astute investor has probably noticed that bond returns have leveled off. The Barclay’s Aggregate Bond Index has produced a pedestrian five-year return of 2.2% for the period ending 12/31/16. Basic math dictates that bonds will be hard pressed to mimic their results from the last 35 years, especially as interest rates begin to slowly float upward.
How Investors Typically Adjust to Lower Expected Returns
Investors have always had a basic dilemma when investing. You can invest in assets that are riskier, but tend to offer higher potential returns. Alternatively, you can invest in safer assets that may pay a steady stream of income, but will likely experience lower long-term returns.
Whenever investors face the dilemma of lower future returns, they generally have the following three options:
- Become accustomed to taking greater risks by owning fewer bonds and holding more assets with a higher return profile, making your portfolio more volatile.
- Save more of your income before retirement or reduce your spending after retiring.
- Earn less on your portfolio without adjusting the amount of risk in it.
Unfortunately for investors, none of these options are that palatable on their own, nor are they even feasible for most people. Because of that, it’s not uncommon for investors to use a combination of the three options within their financial plan.
While this is a prudent idea, there is another mechanism working in investor’s favor that I believe merits more attention.
A “Real” Solution for Investors in a Low-Yield Atmosphere
Rather than thinking about investment performance nominally, focus instead on real returns. While the headline investment return numbers may appear muted in the future, the real return (returns after deducting inflation) could easily be in the ballpark of what has occurred historically.
Measured on a real basis, the long-term returns of equities and bonds have been between 5-6% and 2-3%, respectively. This means that if inflation continues to clip along at about 2%, an investor wouldn’t need to produce the double-digit returns that you’ve become accustomed to. Instead, equities would need to earn 7-8% and bonds would only need to earn 4-5% in order for your portfolio’s performance to remain in line with historical results.
Thinking about investing in terms of real returns helps you avoid falling into the trap of chasing yield. As mentioned earlier, you may be tempted to increase your asset allocation in stocks. This can force you to assume more risk than you’d otherwise be comfortable with.
Other investors, to counter low interest rates, are flocking to dividend-paying stocks as a means of generating regular cash flow. This is causing high-yield dividend stocks to be pushed up to levels that are starting to look overpriced. On the fixed income side, investors may be loading up on junk bonds with higher coupons, thereby exposing themselves to greater default risk than if they had stuck with investment grade bonds.
The overwhelming number of investors trying to push the bounds of their risk tolerance in order to generate unrealistic returns may be doing themselves more harm than good. The next time you’re lying in bed worried about how you’ll generate X%, thinking about investment results in terms of real returns can potentially alleviate your fears and prevent you from taking on more risk than is appropriate.