Investment Expectations
A realistic outlook and a smart plan can improve future returns.
By David Yeske, CFP

The U.S. stock market has just ended its third straight year of losses - something that hasn't happened since the Great Depression. What will stocks return in 2003 or during the next decade? How will alternatives to stocks, such as bonds and real estate, perform?

No one can predict the future. But by having realistic expectations for possible future returns, you can take several steps toward building an adequate retirement nest egg - or comfortably maintaining the nest egg from which you already are drawing.

Let's start with the expectations for stocks. In late 2001, nearly two years into the bear market, a survey by the Vanguard Group found consumers predicting a 7 percent return for 2002 - clearly off the mark, as Standard & Poor's finished the year down 23.4 percent - and an annual return of 15 percent for the next 20 years. These expectations came in spite of an annual average return for large company common stocks of about 11 percent since 1926.

To the contrary, there is a growing consensus among investment experts that returns over the next decade will average in the single digits, probably from 7 percent to 9 percent.

What about bonds? Many investors fled stocks and flocked to bonds and bond mutual funds in 2002. This is unsurprising, as intermediate government bonds returned 10.5 percent in 2000, 8.4 percent in 2001, and 7 percent through nine months of 2002 - well above their historical average of 5.5 percent.

Can this trend for bonds continue? Maybe. A major factor in the strong returns for bonds is that interest rates have dropped sharply in recent years. Bond prices move in the opposite direction of interest rates, so the resulting total return for bonds has been good. Many experts believe interest rates can't go much lower and in fact might rise once the economy, and possibly inflation, rev up again. The possible rise in interest rates would drive down bond prices, resulting in lower bond returns.

Real estate has been another strong performer during this time of declining stock values. Real estate investment trusts (reits), for example, returned 26 percent in 2000 and 15.5 percent in 2001. Like bonds, the strong returns for reits are well above historical averages, so their returns may well come back to earth. (Returns for reits were 5.2 percent at the end of 2002.)

Here are some steps to take to make the best of whatever the investment future brings.

Diversify. Failure to diversify is why many portfolios are in trouble. A 2002 New York Times article described a 53-year-old man who moved all his investment capital into a single aggressive-growth stock mutual fund because he felt he had to make up for lost time. If that fund or sector does poorly, he will lose far more than he already has.

Don't get too aggressive. Avoid the temptation to make up for anemic returns by investing heavily in riskier assets in the hope that huge returns will make up the shortfall. The man mentioned in the article in The New York Times runs the risk of suffering great losses by investing all of his money in aggressive-growth stocks only.

Don't chase returns. Most investments run in cycles, and typically the bulk of the strong positive returns occurs early in the cycle. Too often, by the time investors identify and switch into “hot” sectors, those sectors have run their course.

Save more and spend less. A portfolio that loses 25 percent in a single year needs to return 33 percent to get back to where it was at the start of the decline. Instead of trying to earn that back by pinning your hopes on more aggressive assets, a less risky method is to either save more (if you're still building for retirement) or withdraw less (if you're already retired). You can't go wrong with these strategies, regardless of what the market does.