Don’t Get Discouraged by Lower Returns

02/03/2012 11:45 am EST

Focus: STRATEGIES

John Heinzl

Reporter and Columnist, GlobeInvestor.com

It’ll be a tough time ahead, so don’t be surprised if your profits don’t match "historical norms"…although there are lessons to learn to avoid making matters worse, writes John Heinzl, reporter and columnist for Globe Investor.

I’ve read that the stock market has posted long-term average annual returns of 10%. Is this number accurate, and what sort of gains do you think investors should expect in the future?

Stock market returns vary widely depending on the time period studied. That volatility makes it difficult to predict future returns with any accuracy.

For example, in the decade that started January 1, 2000, the S&P 500 sank about 9.1%—or a bit less than 1% annually—including dividends. So that was a terrible time to own stocks. The ten years before that, however, were a great time for equity investors: The S&P 500 soared 431%, or about 18.1% on an annual basis.

Now let’s look at a longer period. A Credit Suisse study by Elroy Dimson, Paul Marsh, and Mike Staunton examined returns for stock markets around the world from 1900 through 2008.

In the United States, stocks grew at an annualized rate of 9.2%, including reinvested dividends. In real terms—after inflation—the return for stocks was 6%, and for bonds it was 2.1%. Canada produced similar results, with an annualized real return of 5.9% for stocks and 2.1% for bonds.

Despite short-term volatility, stocks are still the place to be. They produced the best long-term returns in all 17 of the countries Credit Suisse studied, with most markets posting real returns of 3% to 6% over the 109-year span.

Another conclusion of the Credit Suisse report is that dividends matter—a lot. Assuming all dividends were reinvested, one US dollar would have grown to $582 in real terms over the period in question. Had the dividends been spent instead, the $1 would have grown to just $6—an annual return of just 1.7% annually.

"Reinvested dividends dominate long-run returns," the study concluded. "The longer the investment horizon, the more important is dividend income."

What returns can investors expect in the future? Well, don’t count on the double-digit growth of recent decades to resume.

"We were spoiled by the high returns of the 1980s and 1990s, when equities seemed a surefire route to getting rich quickly," Credit Suisse said.

"Today, as we look ahead…returns could easily come in short bursts rather than gently over time. We need to take a long-term view, and be ready for the inevitable periodic setbacks, which can be severe, while recognizing that there are risks to being out of equities as well."

Justin Bender, an associate portfolio manager with PWL Capital in Toronto, crunched the data and came up with what he believes are realistic return expectations for various asset allocations.

For example, an "aggressive growth" portfolio consisting of 20% fixed income and 80% equities (tilted toward small-cap and value stocks, which have historically outperformed) has an expected annual return, before inflation, of 6.8%. A balanced portfolio split 50-50 between fixed income and stocks has an expected return, before inflation, of 5.75%.

After deducting estimated inflation of 2% and fees of, say, 1.5% (which is less than what many mutual-fund investors pay), we’re left with a real return of 3.3% for the aggressive portfolio and 2.25% for the balanced portfolio. Taxes would take another bite out of these returns.

That’s a far cry from 10%.

There are several lessons here. The first is to keep your fees as low as possible.

The second is to invest a portion of your portfolio in equities—which, though volatile in the short run, are still the best-performing asset class.

The third lesson, Bender said, is that investors "have to start being more realistic about what their portfolio is going to do."

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