The Psychology of Lower Returns

“Building a plan around the phrase ‘sometimes you get lucky’ is not a plan.” – Cliff Asness

Bloomberg aired a great sit-down interview with John Bogle and Cliff Asness last week. They covered a wide range of topics, but the one I thought was the most important for investors was that both agreed we will likely see a period of lower than average returns in U.S. stock and bond markets going forward.

Bogle guessed that over the next decade we could see 7% returns in stocks and 2% or so in bonds, much lower than the 10% and 5% investors are accustomed to historically. That means a typical 60/40 portfolio would earn 5% a year. Not terrible, but that’s 40% lower than the 8% number most investors use for their expected return calculations.

For the bond component, you can’t predict their returns with complete certainty, but bonds are more or less based on math. Over longer time horizons, say a decade or more, bond returns tend to track their starting interest rate levels (see here). Bond interest rates are actually a decent predictor of future performance. Interest rates are extremely low right now.

With stocks, there’s really not much rhyme or reason. Stock performance is based on emotions, trends, fundamentals, supply & demand and sentiment. Higher valuations tend to lead to lower future returns, but there are always outliers in the data. Returns will be what they will be and they’re really dependent upon the end date you choose for measurement purposes.

So there’s really no way to tell if Asness and Bogle are correct about this prediction. But when you’re planning ahead for expected future returns it’s actually better to underestimate and be surprised on the upside than overestimate and be surprised on the downside.

Logically this would lead to saving more money or trying to earn more to make up the difference. But that’s not always the case as many investors take on more risk than they are willing or able to handle to make up for a perceived shortfall between actual and expected performance.

Here are some more considerations if these low returns come to pass:

1. Poor stock market returns are usually consistent with increased levels of volatility. These types of markets put investors on edge. People seem to always have their finger on the trigger, ready to buy or sell after a quick move one way or the other. Lower interest rates on bonds also lead to an increase in volatility because there isn’t as much of an income buffer. They become more sensitive to rate moves because even a minor change in rates can have a large impact on price.

2. It’s tempting to try harder in this situation. An offshoot of the volatility issue is that investors try to predict which way interest rates and stocks are going to boost performance. Trying to guess the tops and bottoms only compounds the volatility, especially if you’re trying to do it on a consistent basis. You end up whipsawed with higher transaction costs and lower returns from market timing misses.

The temptation to time the market increases, but it doesn’t become any easier. Discipline and patience will be more important than ever.

3. Costs matter more than usual. Costs are always important, but if returns do end up being lower, they become even more important than ever. A 1% fee on an 8% gross return eats up over 12% of your total performance, but a 1% fee on a 5% gross return takes up 20% of performance.

4. Investors are terrible at estimating performance. As bad as investors are at estimating future returns, we’re even worse at knowing what our actual returns are. A study by AAII showed that investors overestimated their own investment returns by an average of 3.4% relative to actual results. And in relation to the average investor they overestimated by 5.1%.

Remember, investors aren’t entitled to certain performance targets just because they’re needed. Jason Zweig once said that we get the returns we deserve:

There are a few basic principles that people should keep in mind. There’s an old expression on Wall Street that I’m very fond of, which is: “You get the returns you deserve.” People who had gotten to the point of believing that high returns were a given didn’t deserve to earn them, because the markets don’t exist for our convenience.

Nobody knows if Bogle and Asness will be right on this. Either way it makes sense to prepare your portfolio for a wide range of possibilities.

Lower your expectations. Diversify. Rebalance your portfolio.

But don’t try to guess what happens next.

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  1. Robb Engen commented on Oct 03

    Thanks for the mention, Ben! One thing I make sure to do as an investor is track my portfolio rate of return and compare it to a couple of benchmarks to keep me honest. I still don’t know if the outperformance is due to skill or luck, but I’m starting to lean toward the fact that it’s luck 🙂

    • Ben commented on Oct 03

      I think you’d be surprised by the amount of investors that don’t do this. Staying humble is a great way to keep yourself honest because the markets have a tendency to do it for you otherwise.

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  3. Monevator commented on Oct 04

    @Ben — Just wondering if you have evidence for (1) that you can point to? The reason I ask is that I would expect volatility to actually be lower in a low-return world, because investors are not being asked to carry so much risk for their returns?

    But that is classical economics so quite prepared to be shown it’s right in the theory but has been wrong in practice! 😉