NEW YORK (CNN/Money) - What's the difference between 11 percent and 7 percent? Hundreds of thousands of dollars -- at least when you're talking average returns on long-term stock investments. And that's a difference investors should take into account when planning for retirement.
Stocks have had a great run over the past several decades. Even accounting for the past two and a half years of pain, the S&P 500 has delivered an average annual return of 11.5 percent over the past 50 years through June 30, according to T. Rowe Price.
Experts still believe stocks will remain the best bet for long-term gains, but they expect equities will deliver less than historical precedent suggests. Just how much less is the question.
Of course, making forecasts is a best-guess game. No one knows the future, and methods for interpreting data differ. But on the theory that it's better to prepare for the worst and hope for the best, certified financial planners are advising nest-egg builders to plan for a few different potential returns on stocks, all of which are lower than historical averages.
How low is low?
Stock market returns are based on three major components: dividends, earnings and the price investors are willing to pay for those earnings (a.k.a., the price-to-earnings -- or P/E -- ratio).
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Based on those factors and the historical relationship between stocks and the economy, Ibbotson Associates forecasts an average annual return for stocks of 9.37 percent. That's more than 1.25 percentage points less than the nearly 11 percent average investors enjoyed between 1926 and 2001.
Ibbotson's forecast assumes that P/E ratios can't continue to grow at the rapid rate they have. Between 1926 and 2000, the average P/E ratio for S&P 500 stocks increased 2.5 times. But a disproportionate amount of that growth came during the 1990s, and the current P/E is nearly two times higher than the historical average of 14.
|Portfolio†||Allocation†||Past 15 years*†||Next 15 years†|
|Conservative†||40% stocks; 40% bonds; 20%cash†||9.8%†||7.4%†|
|Moderate†||60% stocks; 30% bonds; 10% cash†||11.2%†||8.4%†|
|Aggressive†||80% stocks; 20% bonds†||12.6%†||9.3%†|
|†*Based on returns through 2001. |
|†Source: T. Rowe Price|
Using a different analysis that looks primarily at earnings growth and dividends, Clifford S. Asness, a managing principal of AQR Capital Management, forecasts returns between 7 and 7.5 percent -- his best-case scenario, unless companies experience higher-than-normal long-term earnings growth, which he doesn't think is likely.
By contrast, T. Rowe Price is more optimistic, forecasting a 10 percent average annual return, based on historical data and analysis of recent market conditions.
So, what's it to me?
Even if you project returns based on the most bullish of these forecasts -- T. Rowe Price's -- you see a notable decline in the projected value of your nest egg than if you use historical averages.
T. Rowe Price looked at the potential growth of various portfolios under two scenarios: based on returns for asset classes in the past 15 years and based on the more modest expectations the company recommends going forward. It assumes you invest $10,000 annually over a 15-year period in a portfolio invested in the S&P 500 Index and the Lehman Brothers Aggregate Bond Index.
|Portfolio†||Past 15 years†||Past 50 years†||Next 20 years†|
During the past 15 years, an aggressive portfolio of 80 percent stocks and 20 percent bonds would have yielded 12.6 percent a year and grown to $440,900. But with the new, more modest assumptions, the portfolio would yield only 9.3 percent a year, growing to just $328,600. And those are nominal returns, before taxes and inflation are factored in.
The bottom line: if T. Rowe Price, Ibbotson and the others are correct, you will need to save more to achieve your goals, or you'll need to reassess your goals based on what you can save.
So, for example, investors with an aggressive portfolio who want to build a $500,000 nest egg in 20 years will learn they need to invest $8,650 a year under T. Rowe Price's new assumptions versus just $5,750 under the old ones. The more conservative your portfolio and/or the lower the return you expect, the more you'll need to put away.
Since you can't know how stocks will behave -- let alone how specific investments in your portfolio will perform -- do yourself a favor and make a few different estimates. Can you still meet your goals if the equity portion of your portfolio only generates 7 percent a year? How about 6 percent a year? Or are your plans only possible under a 10-percent scenario?
'Yeah, whatever. I'm outta here.'
Maybe your attitude is "Oh, keep your forecasts. I'm steering clear of stocks. Better to lock in a small gain in bonds and CDs than watch my portfolio get decimated every week." That's certainly understandable given the beating investors have taken in July alone. But giving in to your disgust might do your portfolio more harm than good long-term.
"People perceive things based on where we are right now," said certified financial planner Ginita Wall of San Diego, Calif. "If you assume stocks will never come back, then you're taking too much risk...because inflation will never go to zero."
In other words, over time, stocks have proven to be a much better hedge against inflation than, say, bonds, which typically have returned a little over 5 percent a year. And although the risk premium (i.e., added return) you get for investing in stocks over fixed-income securities is expected to be less, stocks are still expected to outperform bonds over the long haul.
"Market to market, 20 years from now, I think you'll do better in stocks," Asness said.
Now that doesn't mean you shouldn't have adequate exposure to bonds as a hedge against stock market volatility. T. Rowe Price spokesman Steve Norwitz points out that over the past 10 years through March 2002, a portfolio with 75 percent stocks and 25 percent bonds delivered 91 percent of the return of an all-stock portfolio but only carried 75 percent of the risk. "Ninety percent of the return for three-quarters of the risk? I'd take that trade-off," Norwitz said.
But you shouldn't be so dedicated to fixed-income vehicles that your nest egg won't outpace inflation long-term. In fact, Wall recommends to her clients that for money they won't need for at least 10 years, they put as close to 100 percent of it into stocks as they can stand.
Ultimately, the key to managing long-term investments in a market likely to be far less spectacular than it's been is to have modest expectations but to understand, too, that "there's a risk in investing too conservatively," said Norwitz.