Projecting Future Investment Returns
What should you expect for future investment returns? If you knew, it would greatly simplify your retirement planning. Unfortunately, when it comes to the future, there’s no precision on how it may unfold. However, to do any financial planning, you need to start with some baseline assumptions and I’ll explain how I approach this question.
Over a time horizon of the past 100 years, average annual total return of investment assets have been roughly the following:
- Stocks: 10%
- Bonds: 4 to 6% (depending on the term and the type of bond)
- Cash savings: 3%
Note that these numbers are pre-tax and inflation averaged 3% over this time horizon (i.e., low-risk savings accounts returned an amount just equal to inflation).
We now live in a different economic era than much of the past 100 years, and several macroeconomic signals point to weaker future returns for stocks and bonds.
- Interest rates and inflation are low. For 10+ years, central banks across the globe have unsuccessfully tried to nudge inflation up to 2%. And, interest rates on government bonds are near zero in many countries. The real interest rate on government bonds (i.e., the interest rate net of expected inflation) is negative in many parts of the world. In the US, the 10-year Treasury bond rate is currently ~1.25%.
- Economic growth, population growth, and productivity gains are all at lower levels than in past decades and the population is aging throughout much of the industrialized world. And, to complicate these dynamics, government debt levels are rising.
- Major global concerns such as the pandemic recovery, global warming, and economic inequality may have negative impacts on future economic growth.
- Lastly, stock market returns have been significantly above historical averages in recent years. For example, over the past 10 years, stocks have averaged closer to 15% annual returns and the stock market P/E ratio (stock price divided by earnings per share) is at a near record high. (It was only higher in 2002 and 2009 — an ominous indicator.)
All of these raise yellow flags for future investment returns.
Now that I’ve rattled your nerves about your life savings, I offer two caveats.
- While describing the past is easy, no one knows much about the future. The more certain someone sounds, the more you should discount what they’re saying. This includes me. However, you need to use some baseline numbers to do any kind of planning for the future and an educated guess is as good as any place to start.
- If you had asked me this same question 10 years ago, I would have answered it similarly as most of the trends I noted were already emerging at that time. I also would have been quite wrong as it was a record decade for stocks and also not a bad time for bonds.
Keep this in mind.
With that preface, for the reasons I outlined above, I expect future returns from stock and bond investments to be substantially lower than in the past. When I do financial planning projections for clients, I tend to assume a 7% rate of return for stocks, 1 – 2% for bonds, and 0% for cash savings. If that sounds depressing, other forecasters with more expertise are more bearish than I.
As a client nears retirement, I assume her asset allocation will not be invested 100% in stocks. Perhaps it would be 90+% stocks at a young age, 60% stocks as retirement looms, and slowly gliding toward 30% stocks in the later post-retirement years. As I average out the asset allocation over time, I tend to use a blended rate of return of ~4% in most situations where clients are near retirement age.
Is this too conservative? I don’t know (no one else does either). But, if you want to use a higher rate then you either have to take more risk by shifting your asset allocation to a greater proportion of stocks or you have to ignore the concerns I raised about macroeconomic trends pointing toward lower future returns.
What should you do?
As I like to tell clients, focus on what you can control. That is, spend within your means, minimize your investing expenses, and optimize your asset allocation for your circumstances and personal risk tolerance. As the future unfolds, you’ll make adjustments as necessary.