The Error-Proof Portfolio: Get Realistic About Future Market Returns

Even if your retirement looms far off into the future, it's worthwhile to think about the nitty-gritty of actually getting there, such as how much you have now, how much you'll need, and how to bridge the gap between the two. If it turns out you're way off and need to save more or recalibrate your retirement date, it's better to know that sooner rather than later.

Essential to that exercise, whether you're relying on a financial advisor, a sophisticated online calculator, or the good old-fashioned "rule of 72," is making sure that you have reasonable return expectations for the asset classes that you hold.

Unfortunately, many retirement plans and pensions are using overly rosy projections for asset-class returns, as Research Affiliates' Rob Arnott noted in a recent commentary. And a lot of individual investors are apt to be making a similar mistake. They may be anchoring on the oft-repeated conventional wisdom that stocks return about 10% per year, or they may be relying on a tool that's using outdated assumptions.

For example, I recently encountered a retirement calculator that was using the following assumptions: 10% for stocks, 6.5% for bonds, and 4.75% for short-term bonds. That stock-return assumption is quite optimistic, particularly given the very strong runup we've seen in stocks during the past year and a half, but it's theoretically possible. However, a bond return of close to 7% is very difficult to justify. After all, bond yields have historically been a very good predictor of future bond returns. And with intermediate-term bond yields hovering around 3%, it's tough to imagine today's bond investors earning double that amount in the decades ahead. For a soon-to-retire investor with a high share of his portfolio in fixed-income assets, relying on that calculator's output could have disastrous results. Such an individual could retire at 65 only to find that his portfolio would only last another 15 years at his current spending level.

Similarly optimistic return expectations abound, unfortunately, both online and offline. It's a dirty secret of the advice world: Investors often shop around for advisors who tell them what they want to hear. And for a client who hasn't saved enough and doesn't want to make lifestyle adjustments to increase his savings rate, goosing the asset-class return expectations is the only way an advisor makes the numbers work out.

Finding Sensible Projections
Given the varying opinions on expected asset-class returns, some of them overly optimistic, what's a well-meaning retirement-minded individual to do?

A starting point is to get your arms around what might be reasonable future-return expectations for various asset classes, so you'll know when to red-flag return assumptions that look overly rosy. Rather than settle for the logic of a single guru, my advice is to sample a range of opinions. For example, Research Affiliates lays out its (admittedly bleak) asset-return expectations in this article, while financial-planning guru Harold Evensky shared slightly higher-return expectations in an interview earlier this year. Vanguard founder Jack Bogle discussed his intuitively appealing approach to asset-class expectations in this video.

As you survey the prevailing wisdom on asset-class returns, be sure to note whether the prognosticator is factoring inflation into his or her projections and the time horizon for the projections. It's also worth noting that asset-class return expectations are often rooted in current asset-class valuations, so securities' prospects will become more or less attractive as time moves forward. If you see market-return expectations that are more than a year old, be sure to take them with a very large grain of salt.

Where the Rubber Hits the Road
Because market-return expectations can vary so widely, those looking to online tools for guidance about whether they're on track to meet their goals should sample an array of them rather than deriving a false sense of security from a single tool that's projecting lush stock- or bond-market returns. As you do so, be sure to read the fine print about return expectations and methodology.

 Morningstar's Asset Allocator tool for example, assumes a 1% projected return for cash, 3% for bonds, 8.5% for U.S. large caps, 12.5% for small and mid-caps, and 9% for foreign stocks. Those returns are real--that is, adjusted for inflation. I think the equity projections, in particular, are on the optimistic side, so it's important to bear that in mind when assessing the tool's output.

And if you work with an advisor, be sure to grill that person on the returns he's projecting for various asset classes. If they seem unrealistically high, such as the aforementioned 6.5% return for bonds, ask the advisor to ratchet them down to a more realistic level. After all, it's better to save too much while you're still working than scramble to make up a savings shortfall just as you were getting ready to retire.

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