What Do Low Market Return Expectations Mean for Your Plan?

Sane investors know that trying to predict what stocks and bonds will return is close to impossible. So why, they might reasonably ask, bother with experts' forecasts?

The reason is that future market returns are one of the levers in our financial plan. Without some expectation of how much of a gain your portfolio will kick in, you can't know how much to save, how long to save, and whether your financial goals are realistic. Even the most rudimentary financial calculators require you to punch in a return assumption for your portfolio.

To help you arrive at an educated guess, I've begun compiling an overview of long-term return expectations from a variety of individuals and firms each year; here's the most recent version, and here's the 2017 version. Note that I'm only interested in the long view, as predicting short-term returns is especially challenging; most of these experts provide return forecasts over a 10-year horizon, though one (GMO) uses a seven-year horizon.

Unfortunately, the most recent run of data is even bleaker than the 2017 version: These experts' return expectations for U.S. stocks ranged from decent Schwab Investment Advisory, 6.7% for U.S. large caps as of August 2017) to devastating (GMO, negative 4.4% real returns for U.S. large caps over the next seven years). While emerging-markets equity was one bright spot in a few of the forecasts (Research Affiliates, Morningstar, GMO), most of the forecasts for U.S. equity were bunched in a depressing range of low single digits.

The question is, how should you use this information--or not use it? Here are some thoughts.

Buckle Up Reading through the return expectations, you might think, "3% or 4% annually? I can live with that." But never forget J.P. Morgan's response to a query about how the market will perform: "It will fluctuate." His point was that equity returns are usually all over the place from year to year. En route to delivering a 9% annualized gain over the past decade, for example, the market served up seven years of double-digit returns, two years' worth of tiny gains, and one doozy of a 37% loss. It's likely that the next decade will feature a performance pattern that's similarly erratic, and probably even more so. And if the generally pessimistic market forecasts discussed in last week's article pan out (and of course this is an open question), there will likely to be larger downward variations than we've had recently.

Shorter Spending Horizon: Take Muted Return Expectations to Heart Note that the experts quoted in my article shared market expectations for the next seven to 10 years. Thus, their return estimates are really the most relevant for people who have a spending horizon of similar length: investors who have money earmarked for near- or intermediate-term goals, are getting close to retirement, or have just begun drawing upon their portfolios in retirement. That's the cohort for whom a bum sequence of returns--hefty losses just as they're starting to spend from their portfolios--is a particularly big risk. After all, spending too much from a portfolio as it's declining leaves fewer assets in place in the portfolio to recover and heal.

There are a few key ways that folks in this at-risk contingent can protect themselves in such a scenario. A major defense is being willing to rein in spending if a market downturn materializes; financial planning guru Michael Kitces believes that a 4% initial portfolio withdrawal is still a reasonable starting point for new retirees. But cautious types, those with very conservative portfolios, and those with very long time horizons of more than 30 years will want to stick with an initial withdrawal rate of 3% or even less. Proper asset allocation can also be a defense if your early retirement years are rocked by bad market returns: Holding enough in safe assets like cash and bonds, as with the bucket strategy, can keep retirees from having to tap their equity assets when they're in a trough.

Less Caution Warranted for Longer Time Horizons By contrast, if your time horizon for spending your money is far out into the future--say, you're a 30-year-old who is steadily dollar-cost-averaging into stocks via a 401(k) or IRA--there's no reason to let weak seven-to-10-year forecasts have a big impact on your outlook or your actions. Because it's just one bump in a long road, a lousy market run in your 20s, 30s, or 40s (or even early 50s) probably isn't going to make or break your plan. Instead, you can reasonably use the stock market's long-term historical return of 8% to 10% as a baseline, though you may want to give that number a bit of a haircut to account for today's relatively high equity valuations and the possibility that returns over the next decade might not be so hot. For investors with 25 to 30 years until they'll begin spending, a 6% to 7% return expectation for stocks over that time frame seems reasonable.

More Certainty Required = Lower Return Expectations Time horizon until your spending commences is a key determinant of whether you assume cautious market returns or employ return assumptions that are closer to historic norms. But another factor in the mix--regardless of experts' market return expectations--is how much uncertainty you're comfortable with in your plan. If the answer is very little, then you'd want to be more cautious about any return assumptions you employ, understanding that doing so will require you to do the heavy lifting on the savings front to help offset the potential for meager market returns. On the other hand, if you can live with the prospect that market returns could be lousy over your time horizon--and understand that that could have implications for your eventual goal (you could have to reduce your spending in retirement or defer your retirement date)--then you could reasonably run with a higher return expectation. Seek Out an Array of Opinions One of the great findings of research into human behavior is that we all have a tendency to look for confirmation of what we already believe--whether it's our political views or are investment outlooks. Several posters, in response to my article summarizing experts' forecasts, noted that the experts I relied on for the article leaned toward the gloomy. In hindsight, that probably reflects my own biases toward A) the importance of starting valuation in determining future market returns; and B) my belief that when it comes to reaching or missing important financial goals like retirement, most people would rather be safe than sorry. For me, reader comments accentuated the idea that I should seek opinions that challenge those biases. If your own investment inclinations tend to run to the sunny side of the street , you, too, owe it to yourself and (your portfolio) to seek out opinions that run counter to your own world view.