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Realistic Returns
Are Your Expectations on Track?
This article has been provided by our parent company, and unless otherwise noted any references to rates or returns are based on $US and specifically relate to US markets.
When making investment decisions, many investors tend to place too much emphasis on recent market behavior. Unfortunately, both equity and bond markets are volatile and cyclical, so this emphasis can result in return-chasing behavior that is not likely to produce good investment results over the long term.
Do You Know How to Prevent this Return-Chasing Behavior?
Knowledgeable investors take a broad view—looking at a longer history of capital markets and at more factors than just the recent history of returns. Here are some things to consider before establishing your investment strategy and building your portfolio:
History of Stock and Bond Returns
The differences in returns between these two major asset classes are the primary factors in asset allocation decisions.
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- Average annualized return for US equities from December 1970 to December 2003 was 11.8%, while the return on bonds was 8.5%1. Even though stocks have a higher average return than bonds over this period, there are frequent and sometimes long periods where bonds outperform stocks.
- Average annualized return for Canadian equities from 1954-2003 was 11.6%, while the return on Canadian bonds was 8.0%. Even though stocks have a higher average return than bonds over this period, bond market losses tend to be modest compared to stock market declines. Over the past 50 years, the five worst calendar year returns for Canadian bonds were not nearly as harsh as those for Canadian stocks. The largest decline in bonds amounted to only -7.42% (1956), compared to the largest decline in stocks which was -25.93% (1974).
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How does this data impact your future investment decisions?
Making assumptions about potential returns can be vitally important for you, because reaching your financial goals may depend on it. Unfortunately, in predicting the future, all we have to go on is the past. Using the US market as a template, Russell's forecasting process divides any asset return into three components:
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- Risk premium over the return on intermediate US Treasury bonds
- Expected real return on intermediate US Treasury bonds
- Expected inflation
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A good starting point for long-term forecasts of each component is the average value of that component over a long sample period. At Russell, we typically use the period 1970-2003, with these results:
| Arithmetic Averages, 1970-2003 |
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| (US Market) |
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| Expected Inflation |
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4.70% |
| Expected Inter. T-bond Real Return |
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3.80% |
| Equity Risk Premium |
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3.30% |
Can we do better?
We do have other information for each component that may improve our assumptions. Here are the details for the US market:
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- For the equity risk premium, a valuable alternative approach to using historical returns data is to build up forecasts of the equity premium based on the fundamentals of equity return—dividend yield and earnings growth. Based primarily on this fundamental approach, Russell assumes an equity-risk premium of 3%2. This 3% value is close to that found by other researchers and is well within the range of error of the arithmetic average equity risk premium over the period 1970-2003.
- There is reason to believe that the 3.8% real return on intermediate Treasury Bonds over the period 1970-2003 is a little too high for a forward-looking forecast. Over this period, interest rates declined. There is evidence that investors failed to predict this decline, and this resulted in unexpectedly high total returns. Going forward, we do not expect investors to be systematically wrong. Adjusting for this error, our estimate of the expected intermediate T-Bond real return is 3%.
- Finally, we come to inflation. This is the most problematic of the three components to forecast. The world has experienced a very wide range of inflation. Conceivably, the United States could have anything ranging from double digit inflation to deflation over the next 20 years. Our forecast for long-term inflation is 3%. We base this number on the level of US inflation during "normal times," where we define "normal" as a period that does not have high inflation generated by extraordinary events.
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Putting this additional information together, our long-term assumptions for each of the components of return are:
| Long-Term Forecast |
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| (US Market) |
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| Expected Inflation |
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3.00% |
| Expected Inter. T-bond Real Return |
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3.00% |
| Equity Risk Premium |
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3.00% |
Thus, the long-term expected return on intermediate Treasury Bonds is 6%, and our forecast equity return is 9%3.
What Should an Investor Do?
Equipped with this perspective on market returns, what should you do to design an investment strategy that will work in the long-term? How can you avoid the temptation to chase returns and the possible disappointment that comes with it? The best answers to these questions start with investing fundamentals.
Asset Allocation
At the heart of any knowledgeable investment strategy is an asset allocation. The primary decision for you is determining the appropriate mix of equity and bonds. This decision, more than any other, will determine the long-term performance of your portfolio. However, it is also important that within each of these two broad asset classes, you have a diversified exposure to all segments of the market.
While by no means trivial, designing a good asset allocation is the easy part. The hard part is sticking with it in good times as well as bad. Following your chosen asset allocation requires the discipline to constantly rebalance back to the allocation, selling equities into bull markets and buying equities as the market declines.
Active Returns
Return comes from market return, represented by common equity and bond indexes, and active return, the value added to market returns by skilled investment managers. Compared to market return, active return generated in a risk-controlled strategy such as Russell's MULTI ASSET MULTI STYLE MULTI MANAGER approach is a lower variability source of return.
These active returns do not have to be heroic in size to be valuable. They may seem like a rounding error over short periods of time when the market return on equities is positive or negative 20%, but when compared to long-term expectations of 6% for bonds and 9% for equities, they can make a very significant contribution.
With this understanding of the nature of long-term returns, you can build a practical, realistic investment strategy that fits your time horizon and risk attitude. Ultimately, however, research shows that your long-term success requires determination to stick with your plan—while keeping your expectations and actions firmly rooted in reality.
1 All historical returns in this essay are the annualized arithmetic average of monthly returns. For forecasting purposes, the arithmetic average return, rather than the geometric average, is appropriate. Based on Russell research by Gardner, Grant; Hall, Michael; and Oberhofer, George. "Rationale and Implications of Russell's Recommendation that Clients Use a 3% Equity Premium for Asset Allocation Studies." Russell Consulting Practice Note 44, May 2002.
2 Based on Russell research by Gardner, Grant; Hall, Michael; and Oberhofer, George. "Rationale and Implications of Russell's Recommendation that Clients Use a 3% Equity Premium for Asset Allocation Studies." Russell Consulting Practice Note 44, May 2002.
3 The forecasts used in Russell's asset allocation tools and advice are slightly different that these. This is due primarily to the incorporation of a simple yield model that takes account the difference between the current yield on T-bonds and a likely long term value. When interest rates are historically very low, we expected them to slowly rise, depressing expected return relative to those levels we present here. We expect the opposite effects when interest rates are very high.
Copyright© Frank Russell Company 2004. All rights reserved. See Important Legal Information and Sales Diclosures. Date of first use: 10/08/2004
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