Should you expect lower returns from stocks?

Expected returns from stocks are important in investment planning; using the wrong numbers can mean trouble for a portfolio. A new study helps shed some light on the expected returns of stocks, and it's not good news for people expecting the high returns to continue.

The study, "The Expected Real Return to Equity," used a model capturing the present value relationship linking dividends, earnings, and investment-to-market values via expected returns. The model produced an estimated expected real return to stocks ranging from 4 percent to 5.5 percent, quite a bit lower than the historical real return of around 7 percent. In addition, the analysis indicates that expected returns have declined by about 2 percentage points over the past 40 years. (It should be noted that the study covered the period 1966 through 2009 and excluded financial firms and regulated utilities.)

This estimate of the future real return to stocks is consistent with the estimates made by professors Gene Fama and Ken French in their 2002 study, "The Equity Premium," as well as the estimates from several other studies over the last several years.

The importance of a study such as this one comes about because many investors, both individual and institutional, use backward-looking indicators (that is, historical returns) to estimate future returns. If historical returns portray too rosy a picture, severe problems can result. For example, pension plans will be underfunded if they expect stocks to provide their historical real return of about 7 percent, but forward-looking measures estimate the real return at just 4 percent. Individuals will have to save more for retirement and/or plan on working longer. In addition, risk averse investors who expect stocks to provide a 7 percent real return might allocate a lower percentage to stocks than if the expected real return was just 4 percent.

Why have expected returns fallen? One explanation offered is that the Great Depression led to an increase in the market price of risk that has slowly dissipated over time. Another is that increased participation in the stock market might have lowered the expected returns to stocks.

Financial economists seem to agree that expected stock returns are quite a bit lower than historical returns. This has serious implications for investors who shouldn't build plans based on backward-looking measures, which seem likely to leave them well short of achieving their financial goals. If you've been using historical returns in your plan, you should reconsider before it's too late to make appropriate changes that would provide you with a more reasonable chance of achieving your financial goals.

[[e-mail]]

Really appreciate your work, Larry...questions:

1. In your book "The only guide to a winning investment strategy," the diversified portfolio produced a higher return with lower variability. Would you use 4% for retirement planning, or some higher number?

2. If you revised "Winning Investment Strategy" today, would you change your "model portfolio" allocations? I've been following that, with the exception that my equities are 50% international.

2. would you make any changes to Appendix I of

[R9619]

Larry,

Follow-up to Looking West's question: is momentum investing consistent with the EMH. If not, why should we expect the strategy to be successful in the future?

Thanks,
Ross

[Looking West]

Larry,

Excellent blog. Have followed you for over a year and the blog is very informative and full of insight. Recently you were quoted in a Fortune magazine article that discussed Clif Asness and AQR mutual funds.

""We're almost certain to offer the AQR mutual funds and recommend them to our clients," says Larry Swedroe, director of research for Buckingham Asset Management"

The "hedge fund-like" AQR mutual funds seem antithetical to the principles and ideas that you advocate in your blog and in your books. I am somewhat confused by your quote and I am having difficulty placing it in context with much of your writings. Could you please provide some broader context to your quote and the AQR funds?

Happy New Year

Looking West

[dapel100]

Great article, and wonderful answers to comments.
Thank you so much for sharing your wisdom

Daniel

[R9619]

Congrat's on the New York Times article on the "Larry Portfolio."

I think this approach employs a value tilt and small-cap tilt.

As I review the performance of 4 Vanguard funds --Value Index, Growth Index, Small-Cap Value Index and Small-Cap Growth Index-- as of the end of the last calendar quarter, it appears (i) the Value Index has underperformed the Growth Index over the last 1, 3, 5 and 10 year periods and (ii) the Small-Cap Value Index has underperformed the Small-Cap Growth Index over the last 1, 3, 5 and 10 year periods.

Can you explain how this 10-year performance should be understood in light of recommended portfolio tilts?

Thanks,
Ross

[LarryswedroeCBS]

Ross
Small and value are risk factors, not free lunches. Just as the equity risk premium is a premium for risk, not a free lunch. If there were no long periods of underperformance it would be a free lunch wouldn't it? There must be that risk. Small and value are riskier asset classes and the risks have shown up in last ten years, just as the risks of stocks have--bonds having outperformed them

BTW, for the last 10 years ending August 11 (latest data I have) the size premium was almost 5% and the value premium was almost 2%.
Vanguard's funds have low "loading factors" relative to size and value compared to funds such as those of DFA and Bridgeway. You can easily see that when you look at weighted average BtMs and market caps. That means they have lower expected returns, and will underperform when the premiums are positives (though likely will outperform when they are negative).

I hope that is helpful

Best wishes
Larry

[johndc43]

Someone should clue in Vanguard who continues to tout historic returns as the best measure of risk/reward.

[LarryswedroeCBS]

Using historic returns is illogical. You have to understand how you got those returns. For example, by 1950 stocks had returned about 7%. So you project 7%. But that doesn't make sense since P/Es were then very low, forecasting much higher EXPECTED returns. By 2000 the historical return had risen to 11.3%. To forecast that would have been the height of folly because you got their not because of higher earnings growth but because expansion of P/E ratios, which could not be repeated.

Forecasted returns should be FORWARD looking, not backward. Financial economists typically use the Gordon Model and based on that come up with estimates of about 7% for the market as a whole

[SantaFean]

Of course. Wall Street is corrupt. Do you need a list? Buying stock today is just plain stupid. As an example....look at what the "analysts" were saying about bank stocks at the beginning of this year, 2011. For every one who said sell there were 100 saying buy! Could you even find a bank analyst at the beginning of this year to say sell bank stocks? Now what are they saying? "Good time to buy banks as they have no place to go but up." Banks have massive liabilities and they say so if you take the time to read their 10K statements. You can see that large investors are STILL dumping bank stocks.

[LarryswedroeCBS]

SanteFe
Unfortunately your last statement tells you nothing about where the market is going. Large investors have shown no more ability to time the market than individuals. In fact a study on over 100 such large institutional investors that were engaged in "tactical asset allocation" found that not one single one benefited from their timing strategies. Not one.
Even Warren Buffett warns investors not to try and time the market but suggests that if you do, you should buy when others are panicking. In fact he has been on the largest buying spree in decades for BRK. Now should we take your advice or his?

Best wishes
Larry