While uncertainty is perhaps the only certainty (besides death and taxes), global markets are paying close attention to two sources of uncertainty here in the US. They are the direction of US interest rates and the outcome of the US Presidential election. With equity and bond market expectations anchored by historically low global interest rates, the Fed may continue to buck the global trend and move US rates higher. Trump’s defiance of forecasts that he would fail in the primaries has introduced a whole new element of uncertainty to this year’s Presidential elections. Rather than make any predictions on the above, we thought we would talk about uncertainty…specifically, as it relates to expectations.
What do we mean? Expectations—for this conversation, investor expectations—will determine the success or failure of a financial plan. All of the inputs to a financial plan are formed by expectations. The answer to the question we often ask clients—“What’s the money for?”—will be influenced by expectations regarding one’s family, health, career, etc. Similarly, the evaluation of an appropriate investment portfolio is influenced by return expectations.
With this in mind, we wanted to bring to your attention a research paper from McKinsey Global Institute (McKinsey) that raises doubts about the return expectations held by many US investors. McKinsey is a leading private-sector think tank and research arm of the global consulting firm, McKinsey & Co. The report made some interesting conclusions, and while they are not a “certainty,” we do think they merit discussion…to help set your expectations, of course.
The basic premise of the study is this: 1) over the last 30 years, the US has experienced historically high investment returns, 2) investor expectations regarding future investment returns are heavily influence by these historically high returns, 3) future investment returns are likely to be lower, and therefore 4) investors likely need to lower their return expectations.
From 1985 to 2014 US and European equities averaged returns of 7.9%, and US and European bonds averaged returns of between 5.0% and 5.9%. These returns were driven by sharp declines in interest rates and inflation; by strong global economic growth; and by advances in technology, which helped advance automation and reduce the cost of goods. Profits of publicly traded companies in North America increased an astounding 65% over this time period. McKinsey argues that these returns are not sustainable, because the economic environment that allowed for these returns is not sustainable. Aging demographics and technology are two of the primary culprits that McKinsey believes will cut into the profit margins of the companies that have been so successful over the last 3 decades.
In order to find a better starting-point for establishing return expectations, McKinsey looked at average returns over the last 100 years. Over this period, US stocks returned an average of 6.5% annually, European stocks 4.9%, US bonds 1.7%, and European bonds 1.6%. Those returns would make the idea of “averaging 6%” on a diversified, balanced portfolio an “interesting” proposition. McKinsey goes much deeper in its analysis, however, and concludes that both stocks and bonds could generate even lower returns than those over the next 20 years. (You can read the report here: http://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/why-investors-may-need-to-lower-their-sights.)
Regardless of what one thinks about McKinsey’s conclusion, we believe the following question is worth asking: what happens to your plan if economic growth and market returns do not return to the levels experienced in the last 30 years? Experiencing returns that are lower than expected can create a “funding gap” in one’s plan. This would force investors to make difficult decisions regarding saving more, delaying retirement, and/or modifying their goals. Many “boomers” are already grappling with these issues following the Great Recession of 2008-2009. For younger investors, McKinsey’s numbers suggest that a 30-year old today will need to work 7 years longer than a 30-year old in 1985 to have the same level of savings at retirement.
We hope that this information encourages you to reflect on your own expectations and how changes in those expectations could impact your plans. And if you haven’t begun to plan, we hope this discussion might inspire you to do so. We are here to help.