February 01, 2017
What Kind of Return Can you Expect From Investing?
What Kind of Return Can you Expect From Investing?
Our wealth management process begins with the preparation of a financial plan for each family. Such plans are based on financial projections that necessarily assume rates of return, but the problem is that no one can predict the future. Past data are all we have to guide us. Yet historical rates of return have experienced wide swings over time. For example, the 10-year US government bond yield rose from 2.0% in 1941 to a high of over 15% in 1981 before commencing a long decline to 2.3% presently. This shows that the long-term average of 4% to 5% cannot be assumed with much confidence, especially when any financial projection we make now would start with yields close to the bottom of the range, 50% below the average and 85% below the 1981 peak.
It is important to note that inflation was rampant in the late 1970s leading up to 1981, whereas inflation now is muted. Any financial forecast must first make an assumption about inflation as this is the primary determinant of bond yields. It also makes sense to build in an assumption about the economy since the real long-term bond yield (i.e. the yield before adding inflation) also relates to the growth rate in real GDP, according to Jeremy Siegel who also maintains that economic growth has slowed due to lower productivity gains and slack growth in employment (given an aging demographic profile).
Like bonds, stocks have experienced a wide range of valuations over time. The equivalent to a bond yield for a stock is the Price/Earnings ratio since its inverse - earnings divided by price - gives the "earnings yield" on a stock. For the S&P 500, P/E's rose from a low of 6.7x in 1980 to over 40x at the tech bubble peak in 2001. While the market experienced downward corrections in 2002 and again in 2008, the current S&P 500 P/E remains quite high at about 26.6x compared to an average of about 15.6x from 1917 to 2009 (a simple Google search will produce this generally accepted number).
General expectations for long-term equity returns can range from 7% to 11%. This makes sense using an average P/E of 15.6x because the earnings yield would be 6.4% which, combined with a long-term inflation assumption of about 3%, would produce a nominal rate of return of 9.4%, about the middle of the 7% to 11% range for stocks. However, as with bond returns, it is difficult to assume such rates of return for stocks going forward with confidence given the wide range in historical P/E multiples mentioned above. Many studies have been done on historical stock returns, but here I will use the work of legendary American investor and author, Ken Fisher (cited in the October issue of Advisor's Edge).
From 1926 to 2009, the annualized return for stocks was 9.7% and the simple average was 11.7%. However, actual rates of return in individual years fell in this range only 6% of the time (5 years out of 84). In two-thirds of the years, either returns were more than 20% or there were losses of more than 10%. What this tells us is that you have to stay invested over the long-term to achieve the expected average rate of return from stocks, riding out significant ups and downs in individual years. And it is a good idea to hold some cash or short duration bonds in order to rebalance portfolios when equity markets have a major correction that can produce stock bargains.
So what can an investor expect from here? Clearly bond yields offer meagre return prospects given today's prices. Also, interest income is fully taxable and the rate is fixed. There is no protection from future inflation that might occur – inflation is the enemy of bonds. Stocks are expensive relative to the historical range of P/E ratios, but they can offer dividends that meet or exceed bond yields, especially after tax. Plus growth available from stocks does provide some protection against inflation. A fitting conclusion here might be the view of famous value investor and author, Benjamin Graham (summarized in a recent blog by Tom Au, CFA posted on Seeking Alpha):
For Graham, the imperative was not to buy stocks that would beat the (stock) "market" but to buy stocks at prices reflecting dividend yields that would enable them to beat bonds and money market instruments, the latter two yielding an average of 4-5% a year over the 20th century.
The key difference between stocks and bonds was that stocks carried their own inflation fighter; that is, most companies would typically grow at least "one third in 10 years" or an average of 3% a year, in line with inflation. Even a strategy of limiting one's investing universe to "bond-like" telephone, electric gas and water utilities, REITs, energy MLPs and stocks, and other income-producing slow growers in say the food or pharmaceutical industries, might have produced a return not much below the 10% averaged on the Dow industrials for most of the 20th century.
This would be composed of 3-4% inflation-fighting capital gains, and 4-5% dividend yields. Graham felt more secure in expecting 8-9% a year with bond-like risk from the above types of stocks than slightly higher but more volatile returns from more "conventional" industrial stocks, including popular high fliers……Graham and later value purists such as John Neff valued dividends for their "bird in hand" qualities over an equivalent but more speculative amount of capital gains.
I think the key factor in Graham's approach was his focus on dividends. I have written in this space before about the joy of income investing. There is something very satisfying about having predictable steady cash flow coming in each month, especially during those temporary but inevitable market downturns. If you are interested in learning more about investing for retirement income, please call me or click on "contact us".
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