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The right return
Forecasting a portfolio's performance isn't easy -- but it's crucial to setting and meeting goals.
By Walter Updegrave, MONEY Magazine senior editor

NEW YORK (Money) -- QUESTION: I always hear financial advisers say, "If you assume an 8 percent to 10 percent annual return in your 401(k)..." before they go on to tell you how much you'll have when you retire. All the 401(k)s I've ever participated in have hovered around the 1 percent to 2 percent range if not negative territory. As far as I can tell, the numbers are fantasy. Am I missing something? - Jordan P., Cincinnati, Ohio

RESPONSE: I agree that advisers can sometimes be what you might call a little "irrationally exuberant." And some individual investors have even more inflated expectations: a recent survey of affluent investors by J.P. Morgan Asset Management found that on average these investors expected their retirement assets to earn 12 percent a year for the next five years.

Individuals and advisers alike may be basing their projections on the returns the stock market delivered at some period in the past. Depending on what period you look at, the returns you get can vary widely.

Take the 10 years through the end of 1999 - before the 2000-2002 meltdown. Stocks delivered very impressive 18 percent annualized gains.

If you take the 10-year span from 1996 through 2005, however, you get quite a different figure: 9 percent a year.

All that said, however, the fact is we have to make some assumptions about what we might earn on the investments in 401(k)s and other accounts if we're to have any idea of whether we're on track toward a comfortable retirement and how much we need to save in order to increase the odds that we are.

Dragging returns

So what sort of return projections do make sense?

I think the first assumption to make is that when you're investing for retirement, you're talking about investing for the long term, by which I mean 10 or more years. Short-term returns vary too much to make any kind of sensible forecast.

The next thing to remember is that we're not talking just about stock returns here. A diversified retirement portfolio will include bonds and perhaps some cash as well. I think that sometimes people base their return expectations mostly on the returns for stocks, and then feel disappointed that the return on their portfolio that includes a good slug of bonds doesn't measure up.

And let's not forget that the return you eventually earn is net of expenses. So, for example, if the stock market delivers annualized gains of, say, 9 percent over the next 20 years and you invest in mutual funds that largely track the market return but also charge annual expenses of 1 percent a year, you'll get an 8 percent return.

Of course, many people think they'll be able to pick funds that more than make up for their expenses with superior investment performance. Well, good for them if they can pull it off. I think a better way to go is to concentrate on funds that keep expenses down. You can find funds with low expenses and good solid performance by checking out the Money 65, Money Magazine's elite list of recommended funds. Or you can screen for low-cost funds at our Fund Screener.

A reasonable guess

These days, I think returns of 8 percent to 10 percent a year for stocks and 5 percent to 6 percent annually for bonds over the long-term is reasonable.

So if you have a portfolio that's, say, 60 percent in stocks and 40 percent in bonds, you might expect a long-term annualized return of just under 7 percent to a bit more than 8 percent.

That's before investment expenses, so how much of that you might get will vary depending on how much you trade and what sort of fees the funds you own charge.

By no means should you consider this any sort of guarantee. You could do worse if the markets tank or if you make particularly lousy investment choices. Or you could do better if we hit another big bull run or you choose investments that do much better than the market averages.

It's also important - in fact, I'd say crucial - to remember that the long-term projections you hear typically forecast an annualized return for an asset class over many years. You will not get that return like clockwork, however.

In fact, the more volatile the asset, the more that return will vary from year to year. That's why for the purposes of trying to project how much money you might have in retirement - or how long your money might last after you retire - these sorts of projections have limited value.

If you want to do serious retirement planning, you're much better off using calculators, such as our Retirement Planner or T. Rowe Price's Retirement Income Calculator, that take into account the variability of returns by doing "Monte Carlo" or other statistical techniques.

One final note. Granted, this has been a rocky year on the investing front and certainly the floor fell out of the market between early 2000 and late 2002. But the past few have been pretty decent. If you've really averaged such meager returns, I have to wonder what kind of investing strategy you've been using.

It might be worth consulting with an investment adviser. Or you might want to just sign up with a target-retirement fund and get a fully diversified portfolio that's appropriate for someone your age. (For more on how these funds work, click here.) Focus your energy on solving that problem, and you could very well end up being wowed by how much your 401(k)'s performance has improved.

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