I was surprised to see that the modest expectations for returns from equities (”real returns from stocks can be expected to be in the neighbourhood of 4% to 5%”) assumed in the post on Smith Manoeuvre earlier this week came in for some criticism. Fortunately for me, among the “experts” counselling investors to temper their expectations are John Bogle and Warren Buffett.
John Bogle makes a persuasive case for modest returns from stocks and bonds in his Little Book of Common Sense Investing (read review here). He repeated it in an interview with Fortune magazine in December 2007:
Well, the Dow is a peculiar piece of work. The Dow yield is 2.2 percent now, vs. the S&P’s 2 percent. Since I’m expecting a 6 percent to 7 percent return on stocks, the Dow ought to grow at 4 percent to 5 percent a year. So over ten years, growing 4.5 percent a year, it would grow by 55 percent and so it would be slightly over 20,000, give or take. But anybody who is expecting that ought to be prepared for a lot of bumps along the way.
Warren Buffett’s annual letter to shareholders also made the case for modest equity returns in this century:
Dividends continue to run about 2%. Even if stocks were to average the 5.3% annual appreciation of the 1900s, the equity portion of plan assets – allowing for expenses of .5% – would produce no more than 7% or so. And .5% may well understate costs, given the presence of layers of consultants and high-priced managers (“helpers”).
Naturally, everyone expects to be above average. And those helpers – bless their hearts – will certainly encourage their clients in this belief. But, as a class, the helper-aided group must be below average. The reason is simple: 1) Investors, overall, will necessarily earn an average return, minus costs they incur; 2) Passive and index investors, through their very inactivity, will earn that average minus costs that are very low; 3) With that group earning average returns, so must the remaining group – the active investors. But this group will incur high transaction, management, and advisory costs. Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group – the “know-nothings” – must win.
I should mention that people who expect to earn 10% annually from equities during this century – envisioning that 2% of that will come from dividends and 8% from price appreciation – are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. If your adviser talks to you about double-digit returns from equities, explain this math to him – not that it will faze him. Many helpers are apparently direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many as six impossible things before breakfast.” Beware the glib helper who fills your head with fantasies while he fills his pockets with fees.
While anything can happen in the markets, it is more likely that Mr. Bogle and Mr. Buffett are right and it is prudent to have modest return expectations from equities.
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15 responses so far ↓
1 Ben // Jun 19, 2008 at 7:36 am
I am noticing a growing consensus that stock market returns will be subdued in the years to come. I choose to believe this, and have reduced RRSP contributions and increased mortgage reduction efforts, after several years of maxing out RRSP’s. While conventional wisdom says I am crazy to pay down the mortgage while my interest rate is locked in the mid-4’s for several years to come, to me this is an ideal opportunity to reduce the principle that will be exposed to probable higher interest rates upon renewal. I am young and looking to start a family in the short-term, so reducing the mortgage in the face of certain disruption of the second income is the right choice, for right now, with expectations of lower market returns and higher interest rates. And of course, the RRSP contributions I do continue to make are fully indexed…
2 brad // Jun 19, 2008 at 7:59 am
This makes me wonder if part of one’s strategy for retirement shouldn’t include some efforts to cultivate an “inflation proof” lifestyle. Of course there are some vital things that you can’t shelter from inflation (food, electricity, fuel), although you can take steps to minimize your exposure (insulate your home, grow some of your own food if possible, buy used instead of new, etc.). Your Money or Your Life has some suggestions for how to minimize the effects of inflation, some of which involve lifestyle changes that many people may be unwilling to make. I’d be curious to hear about any realistic strategies to minimize the impact of inflation.
As for me, I think the prudent path is to keep pumping as much as I can into my RRSPs because even if they don’t grow much faster than inflation that’s still all I’m going to have for retirement. So it makes sense to me to put even more into my RRSP now (since it’ll grow less than I might otherwise have expected). Like Ben, though, I’m also paying down my mortgage on an accelerated schedule to ensure my house is paid off well before I reach retirement age.
3 Al // Jun 19, 2008 at 8:59 am
It is getting very hard to invest. I agree that stock market returns are going to be less than impressive, at the same time that fixed income returns are lousy. Housing seems inflated. I believe commodities are absorbing the speculative money produced by low interest rates, so there is likely some measure of inflation there too.
I recently set up a self directed RRSP, and while I don’t plan on selling my holdings in it, I won’t likely buy anything but short term fixed income until things play out. My monthly contributions will continue but will stay as cash (got to get that tax break).
4 A happy user // Jun 19, 2008 at 9:37 am
I just think this means there is no such thing as a long-term free lunch. Even at 4-5% real returns (7-8% nominal), a well balanced investment portfolio offers good incentives for saving. It is still better to pay down high interest debt, if any, of course.
As to whether to pay down low-interest debt or invest, the flip side of the SM discussion we were having on the post 2 days ago is that the two are very close
a) Long-term returns on investment are still likely to be slightly higher than low-interest debt costs - as you would expect, given the higher risk
b) Merciless attention to costs is key - the difference in costs between a low-cost DIY ETF portfolio and a high-cost mutual fund can be in excess of 2% p.a., and the difference in interest rates on a mortgage based on how aggressively you shop around and what conditions you accept can be over 1%
c) Tax arbitrage opportunities are important - whether or not your investment returns are tax-deferred (efficient retention of capital gains, tax deferral through RRSP), and whether or not your loan interest is tax deductible, make enough of a difference to change the answer
d) The good news is that since the optimal answer is sensitive, it means you can’t go far wrong by choosing whatever you intuitively prefer and executing well - so worry less about what is the exact best strategy, and more about making sure you save, get a good mortgage rate, diversify your portfolio, and keep costs down
5 Canadian Capitalist // Jun 19, 2008 at 10:11 am
Ben, brad: I’m a huge fan of paying down the mortgage in addition to contributing to the RRSP. If it’s only possible to do one, either is a good choice and paying down the mortgage isn’t an inferior option at all. If we can expect 7% from equities before taxes and expenses, an after-tax 4.5% return starts to sound pretty darn good.
My rationale for the RRSP contributions is the hope that it will fund our early retirement dreams
Al: I let cash accumulate to look for decent entry point as well but it’s a tough game to play. I thought the 20% or so decline in the early part of the year was a good time to put money into stocks. Last year, bonds were yielding around 4.5%, which isn’t too bad. Right now, I personally think stocks and REITs offer some value. Bonds, not so much but they could get interesting with recent increases in yield.
Happy User: The 7% nominal return is from stocks only. It will be less for a balanced portfolio.
Even for low-interest debt such as a mortgage, modest equity returns suggest that it might be better off paying off the debt. Why? The 4.5% or so interest savings is equivalent to an investment the produces as much after-tax return. Would an investor prefer a 5.7% investment with no risk or a 6.7% investment with equity risk? The answer isn’t as clear cut now.
You’re bang on with saving, getting a good mortgage rate, diversifying and keeping costs down. In fact, we keep writing the same thing over and over
6 Dividend Growth Investor // Jun 19, 2008 at 10:18 am
It’s very interesting how successfull investors who have riden the bull markets of their times always forecast “lower” returns ahead. Nobody knows where the market is going to be 10 years from now. Period. And by the way Buffett has always shown skepticicm about long-term returns of the stock market.
I believe that a well diversified portfolio with large cap, mid cap, small cap domestic and international stocks plus some bond allocation would do the trick of performing well over the next several years. ( oh yeah add some real estate, private equity and timber to the mix too if you want)
7 Ben // Jun 19, 2008 at 10:48 am
I too have early retirement dreams (early morning canoeing on a misty lake), so wouldn’t advocate anyone completely cease RRSP contributions. In my case, I prefer to go a little overweight on mortgage right now, and underweight on RRSP:
a) certainty of income disruption in the coming few years to start a family,
b) I am young, and retirement is less important to me right now than assuring household stability,
c) low interest rates mean opportunity to reduce principle more easily now than after rate renewal,
d) uncertain economic times and job security make expense reduction more important (lower monthly payments upon rate renewal)
e) low expectations of stock returns, and
f) guaranteed after-tax no-risk return on mortgage return vs. equity risk with slightly higher return.
It’s all about balance, and that balance can (and should) shift as one progresses through life’s stages. As my mortgage decreases, I would expect to once again increase my RRSP’s.
My philosophies: marry a “coupon queen”, maintain cash cushion for life’s curveballs, spend on what you value not on consumption (hopefully they are not one and the same), track monthly expenses and earnings to ensure positive cashflow, direct positive cashflow to the mortgage, and skim RRSP contributions directly off paycheque.
8 Thrifty // Jun 19, 2008 at 10:51 am
CC, I believe both of your references are talking about US stock market. How is the developing world return going to be is unknown. For people pursuing anything more than 5%, it pays to understand emerging markets.
9 Canadian Capitalist // Jun 19, 2008 at 11:03 am
DGI: “Nobody knows” is absolutely right. But we’re talking about odds here and the odds are very high that Bogle and Buffett are likely right. Also, I understand long-term as at least 20 years. The problem for equity investors today is dividend yields are low and valuations are about average. That does imply modest returns.
Ben: I meant to say “My rationale for the RRSP contributions first…”. There is absolutely nothing wrong with choosing to pay down the mortgage over RRSP contributions. In fact, like you point out, it may even be the better alternative.
10 DividendMan // Jun 19, 2008 at 12:55 pm
Hrm - I’m skeptical about this as well. Just look at the Canadian banks right now, you can get a 5% yeild just from the dividends, and I think we can agree that in 100 years the banks will have more customers and more fees to collect, so they probably have some capital gains potential. But like thrifty said, I think Buffet et al. are referring to the American markets.
11 slickvguy // Jun 20, 2008 at 1:11 am
What WEB doesn’t point out is that even at modest rates of return, if the Dow does return about 7% per year for the next 92 years, it would be over 5,000,000 !
Put me in the nobody knows camp. As big a fan as I am of WEB and Bogle, when they talk like this they just prove to me that they’re SOMETIMES fallible humans just like the rest of us.
For a guy who preaches not caring about macro factors, WEB sure has been making a lot of big picture predictions lately. Hmmm….
12 Weekend Reading - June 20, 2008 | Million Dollar Journey // Jun 20, 2008 at 5:31 am
[...] tells us to expect modest market returns going forward as explained in his article “Bogle and Buffett’s Modest Expectations“. The most interesting part of the article is that Warren Buffett himself is a big advocate [...]
13 Anon // Jun 20, 2008 at 9:21 am
I do not agree that in 100 years the banks will [b]necessarily[/b] have more customers and more fees to collect.
Competition from online banks may reduce fees and profits. New entrants from overseas, Walmart, etc. may reduce the customer base of each individual bank.
Finally, a black swan may eat one or more of our big 5 Canadian banks over the next 100 years.
14 miked // Jun 23, 2008 at 8:42 am
Go back to 1994 and you will find that Bogle and Buffet made almost the same predictions. Tempered expectations are OK (mine certainly are) but there are so many variables involved that it is simply impossible to predict returns over the next 10 years. They could be double digit (maybe even 20%) or negative. As bad as things look today, the picture may be 100% different 365 days from now and people will suffer from unrealistic expectations. In 2004 the mantra was single digit equity returns. 04,05 and 06 turned out to be great years. In the end, invest according to your time horizon and risk tolerance, keep costs low and don’t obsess over the daily movements. I think that is what people like Bogle and Buffet really preach. They only answers the “prediction” questions when put on the spot or for a book and they always caveat the answer by stating that no one knows for sure.
Someone referred to the Canadian Banks as a great investment. Global competition is going to hurt them in the long run, imo.
15 ghost // Jul 28, 2008 at 10:07 am
I have read somewhere else that Bogle and Buffet expected lower returns in the future. It is good to finally see the source of those comments and the reasoning they give.
My question is, if you expect between a roughly 7%-8% return far into the foreseeable future, why not just look for bonds that pay that much and hold them in a non-taxable account?
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