Market Return Expectations are Too High

One of investors’ favorite past times is to “fantasize” about what returns lie ahead for the stock market. After a catastrophic 2008 (-37% on the S&P 500), and a much better 2009 (+26.46% on the S&P 500), what does 2010 and beyond hold for those brave enough to maintain exposure to equities?

Most investors are exposed to equities through mutual funds, which are liquid and provide a high level of transparency. This allows for investors to switch between funds with relative ease and gain exposure to those sectors of the market and investment strategies that they think will outperform. As such, while most investors do not invest directly into the stock market, the ease of transferring between mutual funds provides some choice and control over returns. The result of this is that investors feel more in control and believe they have the ability to plan their portfolio more accurately according to expected average annual return.

So what return are we looking at for 2010? A national survey last year revealed that investors expect the U.S. stock market to provide average annual returns of 13.7% per year for the next ten years. The survey was conducted by Robert Veres of Inside Information newsletter.

Several investors I’ve spoken to on a personal level believe returns in this region are likely. Some, however, expect returns ranging from 15% to 25%. The most pessimistic I came across was 7%.

What few investors take into account when predicting annual returns is the effect of inflation and fees. A blue collar worker may be paid $60,000 per year, but his actual income will be significantly lower due to taxes (federal, state and costs such as healthcare or insurance which are indirect taxes). At a tax rate of 25%, before rebates and other taxes, the working class individual will take home just $45,000. When it comes to stock market returns, similar logic applies.

The major difference, however, is that inflation is the main consumer of returns. Historically speaking, inflation has devoured 3% per year. A recent research report I read suggests that taxes and fees cut returns by approximately 1.5% per year. From this analysis it’s prudent to assume that returns, on average, are actually 3.5% lower than they appear.

So if 13.7% is what investors are expecting from the market as their net return, stocks will have to return 17.2% per year. According to Ibbotson Associates, since 1926 U.S. stocks have averaged only 9.8% per year. The net return after taxes, fees and inflation is somewhere closer to 6.3%. That is a gargantuan 63% lower than what investors seem to be expecting.

If expectations are too high, which clearly they are, what are investors to do? Many people do not have enough savings in their retirement pool and are expecting such returns to in effect “bail them out”. If the market fails to deliver such returns, investors are faced with a large and very uncomfortable deficit.

One obvious outcome of this conundrum is to increase risk in search of higher returns. This often results in investors taking on too much risk and wiping out even more value than existed in the first place. The already mentioned 37% drop in the market in 2008 means an investor needed a 58% return in 2009 just to beak even! Had an investor used leverage or bought into illiquid derivatives with fanciful returns, losses could be even worse.

13.7%, which doesn’t sound like a lot, is really a very optimistic assumption of what investors can expect. I’d advise you to carefully consider the three effects outlined above and their detrimental impact on your portfolio. It’s hugely important to save as much as possible in order to avert the situation millions find themselves in right now – predicting lavish and clearly unsustainable returns to produce a workable nest egg.

Equity exposure is incredibly important for any investor (I’m 98% in equities), but it’s also very important to remain prudent and realistic in one’s assumptions going forward. Don’t find yourself relying on high stock market returns over the long-term - it’s a dangerous game to play with one’s future!