Portfolio Expectations

by Tim Isbell (#investments)
October 2014, revised August 2015

If you wonder:

  • "What return can I reasonably expect from my investments?"
  • "Should I take more risk on my portfolio, or is it already too risky?"

... then this web page is for you.

First, a little history. Since 1926, the "real return" (adjusted for inflation) for domestic stocks was about 7%/year (including dividends), and for domestic bonds about 3%/year. If history repeats, combining these in a diversified portfolio of 60% stocks and 40% bonds over the long-term would provide an annual real return of nearly:

    (60 * 0.07) + (40 * 0.03) = 5.4%

I say "nearly" because of investment expenses.

Helpful chart

The table below shows what to expect from a very simple, diversified portfolio over an extended period for five different stock/bond percentages (asset allocations). More importantly, it provides a measure of what risk to expect from different asset allocations. Some comments on the chart:

  • Row 1 is a range of asset allocations. It assumes a globally diversified mix of stocks and bonds, such as is available from the Vanguard LifeStrategy Funds
  • Rows 3, 4 and 5 come from chart in Daniel Solin's book: The Smartest Portfolio You'll Ever Own. (Chapter 25, page 104). Row 3 shows actual data for a recent 20 year period. 
  • Row 4 shows actual data for the single worst year in a recent 20-year stretch that includes some very strong periods and two very weak periods. It comes from 
  • Row 5 shows actual data for the worst successive 3-year period during this same 20-year stretch.
 Stock/Bond % of portfolio 20/80 40/60 60/40 80/20 100/0
 Average Annual Return (1926-2014) 6.7% 7.8% 8.7% 9.5% 10.1%
 Average Annual Return (1991 - 2010) 7.4% 8.0% 8.4% 8.6% 8.7%
 Worst 1 year return (1991-2010) -4% -13% -21% -30% -39%
 Worst 3-yr cumulative return (1991-2010) 11% -1% -15% -28% -39%

To choose an asset allocation that fits your risk tolerance: Move through the columns from left to right and choose the Stock/Bond % with the highest stock percentage where you believe you have the courage to stay fully invested through the worst 1 and 3-year stretches. When you reach a column where you might lose confidence and start selling, return to the previous column. That's a good asset allocation for you. (You can find one-year data for an even wider range of stock/bond percentages going back to 1926 at this Vanguard web page: Vanguard Portfolio Allocation Models.)

If I only convince you to read one personal finance book, this is it: The Smartest Portfolio You'll Ever Own. It is easy to read, extremely informative, and very practical. And it includes wise teaching and additional data about evidence-based, low-fee investing.

Don't be surprised that Solin's actual returns vary from the calculated returns in Row 2 (above chart). We need to start with some portfolio return model that we can use for planning purposes and accept the fact that actual returns will vary. I use the Row 2 numbers for long-term planning purposes (such as when I'm in retirement) though I sometimes modify my short-term expectations as a function of the current economy. The chart above is the best approach I know for managing long-term returns and risks. 


Beware... 

Don't believe all the marketing hype that encourages investors to time the markets, or its segments. By this, I mean, ignore advice such as "It's time to buy (or sell) Apple." Or "It's the time in the business cycle to buy (or sell) commodities." And beware of money managers who promise to time the markets for you. After fees, expenses, and the higher taxes which are built into such arrangements, money managers won't do any better than the results described in this web page - in fact, the evidence says they'll do worse. (Read Solin, Bernstein, or a host of others). 

Practical Expectations for the next ten years

Since the Great Recession of 2008 and the subsequent spectacular stock market rise that is well above historical numbers, many professionals now (August 2015) predict lower returns for the next several years. For example, here's a quote from a Vanguard article in 1/2015: 

"Vanguard's global stock and bond market projections are our most muted since 2006. Over the next decade, we estimate the most likely average annual return (not inflation adjusted) for global stocks to be centered in the 5% to 8% range. By comparison, stocks have returned nearly 10% per year from 1926 to 2014, and more than 20% annually since the bottom of the financial crisis in 2009." 

Other professionals say pretty much the same thing. I agree. Wise investors now expect that the next ten years will compensate with lower real returns (inflation adjusted) in the range of 3-5% for the stock market and 1-2% for the bond market. For planning beyond ten years, investors can expect a reversion to the long-term norms of 7%/yr real return for stocks and 3%/yr for bonds.

The next ten years will tempt investors to reach for higher returns by increasing their asset allocation to stocks beyond what fits their risk tolerance, trying to beat the markets with stock picking, moving to higher risk bonds, and believing the hype to invest in actively managed funds. These increase your risk and expenses, and (I'm convinced) will reduce returns. Wise investors will stick with an asset allocation of mostly index tracking, low-expense investments that fit their risk tolerance - and learn to live on the returns. To think you will beat the returns is "fools gold."

Good to know

For more about the mix of stocks and bonds in a portfolio and how they relate to returns and risk, click on Asset Allocation and the Efficient Frontier.

After you read Daniel Solin's book, take a look at William Bernstein's 4-volume e-book series: Investing for Adults. It's a more challenging read, but it is well worth the effort! Here are the four titles:

  1. The Ages of the Investor (investment principles for the different seasons of life)
  2. Skating where the Puck Was (the problem of "chasing returns")
  3. Deep Risk (surviving those financial meltdowns that occur in everyone's investment life)
  4. Rational Expectations, Asset Allocation for Investing Adults (an update and consolidation of the material in the first three books)

For more personal finance authors that I recommend, click on Resources/Links.

Finally: don't be greedy. A 5%/year real return (inflation adjusted) results in doubling your real buying power in 14.4 years. (Wonder where this comes from? See Rule of 72 in the Financial Rules of Thumb).


All the best,

Tim


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Edited with Grammarly


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