More Modest Capital Market Returns

Reality Check: Dealing Effectively with the Expectation for Lower Market Returns

Forecasts for capital market returns in the next ten years are far less robust than historical returns. Investors and advisors need to face this reality and plan accordingly in order to set achievable goals, focusing on variables that can be controlled.

With all of the noise in the news, and the roller coaster ride of market volatility, it might be easy to overlook that the last 30 years have been an exceptional period for investors in core U.S. markets. Long-term investors that stuck with a well-conceived plan earned approximately 8% in a 50/50 balanced portfolio of U.S. stocks and U.S. bonds over the past 30 years. Not too bad, especially when one considers what market watchers are forecasting for the next ten years.

The new norm projected by economists and supported by market valuations is for U.S. stocks to return somewhere between 5% and 8%, and for U.S. bonds to return between 2% and 3% over the next decade¹.  In this environment, a 50/50 balanced portfolio will be hard pressed to achieve a 5% return – before accounting for fees, taxes, or inflation.  The 3% difference in return between our historical experience and our expected experience is profound, and a little sobering.  It’s a reality that investors and their advisors ignore at their own peril.

As the following chart illustrates, a 3% difference in annualized return has a material impact on the value of a portfolio.

What should investors and their advisors be doing?
Capital market returns cannot be controlled by any investment manager. Furthermore, despite the marketing hype, very few managers are likely to outperform the market returns consistently, if at all. In fact, the risk required to have a shot at material outperformance is often imprudent for investors to take, and the cost to do so is arguably not justified by the outcome.

Not all is lost, however.  There are strategies advisors can employ to help their clients achieve their goals in spite of more modest market returns.

1. Build a plan based on proper expectations.
   Advisors need to help their clients understand markets and set realistic goals for their portfolio. It may be tempting to solve gaps in plans using more optimistic projected investment returns - after all, no one knows. However, it’s a very dangerous way to salve an investor’s anxiety. It’s far better to deal in the tough love of modest return expectations, than the catastrophe of a plan that falls apart when results fail to deliver on unrealistic projections.

2. Understand risk and set appropriate objectives.
   It’s a well-established investment principle that risk and return are correlated. If an investor wants the payoff of more return, they need to be willing to take on more risk.  Unfortunately, defining an investor’s tolerance for enduring volatility (risk) can be an elusive task. Risk tolerance for investors tends to shift as quickly as market performance. A better approach is to define the more objective measure of risk capacity based on an investor’s assets and liabilities to determine an appropriate risk level. This creates a more reliable basis for setting a proper objective and a foundation for a more durable plan.

3. Be prepared for volatility and stick with the plan.
   Market volatility is unavoidable, at least if an investor is seeking any kind of meaningful return. Going forward, market swings may be felt even more acutely without the buffer of attractive bond yields. The key for investors is to trust their long-term plan and avert the damage created from succumbing to emotion. The psychological pull to get out when markets have performed poorly (sell low), and reenter after they have improved (buy high) is natural. It’s also precisely the opposite of what is logical for an investor trying to grow their portfolio.

4. Manage expenses.
   Investment expenses can vary significantly depending on account size and composition, as well as advisory services provided. A commonly used bogey for total expenses, including advisory fees, product expenses, and trading costs is 2.00%². On a balanced portfolio’s historical return of 8%, this represents a healthy 25% of the total return. However, looking ahead where our balanced portfolio has a projected return of 5%, the same costs eat up more than 40% of the total return! Clearly, it’s worth investing time in understanding and managing the cost equation. The good news is that there are a number of strategies for bending the cost curve to preserve wealth.

5. Manage taxes.
   For portfolios that are not protected from taxation, actively managing taxes is another important tool for enhancing investment outcomes. Tax consequences typically encroach on wealth when trades and distributions occur. By paying close attention to the tax implications of trades, and which securities are sold to accommodate distributions, taxes can be dramatically reduced. 

   Additionally, capitalizing on tax-loss harvesting opportunities when they occur is an effective way to offset taxable gains and add value. Too often managers overlook tax loss harvesting as a strategy to improve client outcomes, or isolate tax loss harvesting to an end of the year exercise, missing out on opportunities created throughout the year by market volatility.

   A study by Parametric Portfolio Associates over a variety of market conditions showed that incremental value between 0.7% and 2.5% could be added through active tax management³. This represents a significant source of potential value for the taxable investor to make up for more modest market returns.

So, all is not lost.  Markets may not deliver the same absolute returns the next ten years that we’ve grown accustomed to.  But, there’s still plenty of opportunity to improve outcomes on portfolios through the variables that can be managed.

¹ Sources: BNY Mellon ISSG; Fund Evaluation Group 2106 Capital Market Assumptions

² “Average Financial Advisor Fee in 2016.  How Much Does a Financial Advisor Cost?”  AdvisoryHQ, March 25, 2016.

³ Parametric Portfolio Associates, “Estimating Tax Alpha in Different Market Environments”, September 2014