Stop fooling yourself about 8% easy returns
The only way to meet lofty returns goals is to take much bigger risks than in the past
There’s an amazing amount of denial going on right now. Investors are simply ignoring current market dynamics and are still expecting average annual returns of 8.6 per cent, according to a Legg Mason Inc. survey of income investors released last week. Those who were employed expected more than 9 per cent gains, with retirees expecting less. Actual returns have come in markedly lower of late, but hopes remain high.
This is wishful thinking at best and dangerous at worst. Bond yields are near all-time lows. Stocks aren’t paying that much relative to history in terms of earnings yield. Yes, prices could continue to rise, but that’s becoming less certain as central bankers seek to tighten monetary policies.
This new dynamic is no secret to anyone who manages money professionally. It’s alarming that the hundreds of investors surveyed by Legg Mason still have such unrealistic expectations. Alan McKnight, chief investment officer at Regions Wealth Management, said he had seen similarly overoptimistic expectations from non-professional investors he’s spoken with. “People want to look on a historical basis as to what they should expect in the future,” he said on Friday on Bloomberg Radio.
Many tell McKnight they need 8 per cent returns a year; he’ll tell them about 7 per cent is more possible over the next five to 10 years and only with more aggressive allocations to equities and emerging markets. About 5 per cent is more likely. They’ll often stick with their outlooks anyway.
The problem
Here’s the problem: The only way to meet these lofty returns goals is to take much bigger risks than in the past, and to do so at a time when many are already accepting relatively little compensation for bigger gambles. For example, the earnings yield on the S&P 500 is just 4.6 per cent, compared with nearly 6 per cent over the past decade historically, while junk-bond yields are 5.6 per cent compared with 8.3 per cent historically.
Unless people scale back expectations, they’ll likely end up seeking classic methods to juice gains — namely, investing in funds that borrow shortterm money to invest in longerterm assets. It’s important that investors are realistic. If they’re not, fund managers will try to serve their hopes and dreams, making the financial system all the more fragile for it. Sensex (IN)