How big will your investment returns be over the years ahead? We’ve seen some huge gains recently despite wider economic concerns, but can this continue? There is a foul smell in the air and there are reasons to believe that future investment returns will not be as good as they once were.
Today’s post is jam packed – we’re looking at investor expectations, historic returns, a worrying forecast by Credit Suisse, why young people are potentially screwed, reasons to be optimistic, and what you need to do.
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Investors’ Expectations: Are Investors Living In Cloud Cuckoo Land?
In April 2020 Schroders commissioned an independent online survey of over 23,000 people who invest from 32 locations around the globe. From this we learnt that investors on average expect to pocket returns of 10.9% a year over the next five years.
Oddly, this was 1.0% higher than what was expected 2 years prior. Bear in mind that this study was being carried out around the time when Covid was kicking off and we would have thought this would have sent everyone into panic mode.
Winding the clock back, we recall mass hysteria and panic-buying leading to not just some empty shelves but literally empty supermarkets. Based on this you wouldn’t have thought that there was too much optimism in regard to stock market returns. Maybe the average investor is more positive than the average member of the public.
Although the average investor expects 10.9% annual returns it does vary based on region.
Most optimistic are those from the US. Our American friends are well-known for their confidence and in this case, they expect 15.4% annual returns. Let’s hope they’re right – but something tells us this is a fantasy. Some way behind but still massively hopeful are UK investors who expect 11.1% returns annually.
To quote the study, “People have an over-optimistic outlook on their total investment returns.”
Why Are Expectations So Unrealistic?
The Schroders study only briefly touches on why they think investor’s expectations are so high. They conclude that the majority of people are basing their predictions on the returns they received in the past. With huge returns in recent years, especially in the US stock market, you can easily see why this might be the case. Most people have a tendency to show Recency bias.
Recency bias is where someone gives greater importance to more recent events. History tells us that economies and stock markets move in cycles, but it’s easy to forget that when you have 10 years of solid investment gains. Instead, people begin to believe this will continue, especially if they’re new to the game and it is all they’ve ever known.
We also think that the industry and the media like to portray the stock market as a place to get rich quick. It’s the standout performers that make all the headlines. In the UK, Scottish Mortgage has returned around 742% in just 10 years. While over in the US, Tesla has grown over 1,200% in 5 years.
We all want these standout returns but sadly, these aren’t the norm.
Each year Credit Suisse publish the Global Investment Returns Yearbook – a detailed analysis on investment returns going back over a hundred years.
According to the study, over the last 40 years the World bond index has provided an annualized real return of 6.2%, only marginally below the 6.8% from world equities.
The authors go on to say that “extrapolating these bond returns would be foolish as it was the golden age for bonds, just as the 1980s and 1990s were a golden age for equities.”
Although 40 years seems like a long enough period to form a solid conclusion about returns, unfortunately it isn’t. Stocks and bonds are volatile, which leads to major variation in returns. Fortunately, the study goes back 121 years and they found that US equities returned 9.7% before inflation and 6.6% in real terms. Whereas US Treasury Bills only provided 0.8% real returns.
With the power of compounding and 121 years these differences are enormous. With stocks the purchasing power has grown by 2,291 times but only 2.6 times with treasury bills. If you were thinking about investing in short-term bonds that might make you think twice.
Other stock market studies will vary slightly, and we have long held the belief that stock markets have returned around 8% before inflation and 5% after inflation as a conservative measure. So, with the world’s biggest market delivering stellar results in excess of our expectations it gives us a reason to be optimistic.
The US has been the major success story though throughout the 20th century and the beginning of the 21st, so focussing on its performance might not be a fair representation of the overall stock market.
Over the same 121 years UK equity returned 5.4% in real terms. Not bad and on an annual basis not too far behind the US powerhouse. However, compounded over 121 years, a small difference like that makes a huge impact.
Where US equities’ purchasing power has grown by 2,291 times, UK equity has grown by just 572 times.
The study carried out this exercise for 26 countries and found that real equity returns were typically between 3% to 6% per year.
Dismal Returns Forecast
So far we’ve seen that most investors have unrealistic return expectations, while our own are more in line with historical averages, but maybe this is where things are about to get ugly.
According to the same Credit Suisse study, the authors are forecasting an enormous drop in expected returns over the coming decades, which could devastate all our plans to grow wealth and shatter our retirement dreams.
Their method takes current bond yields to indicate future bond returns. Then using this figure, they have forecasted equity returns by adding on their estimated equity risk premium. The result is that they are expecting bonds to have a negative real return of -0.5% and equities to return just +3% after inflation. Just 3%!
If that wasn’t depressing enough, when you run those returns through a 70:30 equity/bond blend as a typical portfolio might look like, the portfolio real returns are a horrifying 2%.
This same blended portfolio would have returned in real terms roughly 6% for previous generations, meaning future returns could be two thirds smaller than what our parents and grandparents’ generations could have earned.
Gen Z & Millennials Are Screwed
If the investment forecasts in the Credit Suisse report turn out to be true, this paints a very dire picture, especially for young people. But this isn’t the only way in which young people are being screwed.
Young people are already having to contend with a property market where house prices have reached what can only be described as ridiculous. Official data says the average UK house is now valued at £267,000, which is a 7.6% annual price rise. We’re betting that most of you haven’t had a 7.6% pay rise this year.
Next, Youth unemployment is already unacceptably high at 14.3%. Young people who find themselves lucky enough to have a job are being thanked for their services with meagre wages. ONS data says the average income for a 20–24-year-old is just £18,400 and only £23,900 for a 25–29-year-old.
Further, Government debt is at eyewatering levels at around £2 trillion. Although high earners are likely to bear the brunt of this in the form of increased taxes, it is the young who will suffer the most. The country will have less money sloshing around that otherwise would have been spent on boosting education, job prospects, and ultimately creating better opportunities.
Also, most people under the age of 40 probably haven’t given too much thought to state pensions but this could prove to be a big mistake.
It’s widely believed that the UK government will not be able to sustain the state pension due to the enormous running costs, which are currently estimated to be around £100 billion a year and climbing. It’s highly likely that it won’t exist in its current form for our generation and those younger.
Reasons To Be Optimistic
Going back to investing returns, there have always been reasons not to invest.
Considering the economic state we find ourselves in it is difficult to disagree with the forecasts put forward in the Credit Suisse report. However, the world moves so fast that we wouldn’t pay too much attention to forecasts that look much further than just a few years.
Would someone in 1950 have predicted the moon landing? Would someone in the 60s have foreseen the internet? Would a 1980s forecaster have predicted that everyone would carry a supercomputer in their trouser pockets within just a couple of decades?
But if these forecasts turned out to be true, a period of low investment returns COULD prove to be a blessing in disguise. When you are young and buying into the stock market it is better when prices are low. Low returns over the next decade would suggest stocks will become better value than what they are today.
Ideally you would want the stock market to go nowhere or even fall while you in the accumulation stage, and then surge right before you wish to start drawing on that retirement pot.
Everyone knows the phrase buy low, sell high, but why does everyone cheer every time the stock market goes up? Unless they’re selling and never buying again it doesn’t make any sense.
Another reason to be optimistic is the reduction in investment fees and improvement in accessibility to the stock market. Past generations may indeed have had much better returns, but they also suffered punishing fees, which would have severely dented any gains. Today we can eliminate fees almost entirely. We can invest in stocks from all over the world for less than one tenth of a percent.
What To Do If Returns Are Dismal?
In terms of our investing style, what we’re doing is accepting more risk, and by that we mean more volatility. The days of getting sweet returns with zero risk are gone. That means we will allocate more of our portfolios to “riskier” assets such as stocks instead of bonds. Bonds provide stability but not the required gains that we need.
Next, we are already allocating a big chunk of our portfolios to emerging markets and small-cap stocks. We’re hoping these themes perform better than larger caps from developed economies and might give our portfolios the boost we need.
It’s essential to keep investing – even at the point of maximum pessimism. Next time the stock market is making the front pages with tales of doom and gloom – buy, buy, buy!
Unfortunately, if returns are going to be dismal, then it’s so important to invest more. If your pot is going to be hampered by low returns, to counter this you can either invest for longer and/or increase contributions.
Our chosen route is to build multiple streams of scalable income, which is where the output reaches a growing audience. As a result, the income is effectively unlimited. We are building scalable income alongside investing, but in theory if you can build this large enough you may not even need to rely on investing to set you free, and so low returns shouldn’t matter too much.
The best thing you can do is concentrate on building that income and channelling it into the stock market.
What do you think investment returns will be? Are we about to have a decade of dismal returns? Join the conversation in the comments below.
Written by Andy
Featured image credit: trendobjects/Shutterstock.com