The Low-Return Imperative: Investing uncomfortably
We all know that successful investing is hard, but does it seem to be getting harder? For many investors the answer is “Yes” for two primary reasons:
- Many investors need fairly high nominal returns to achieve the investment outcomes they seek.
According to a Goldman Sachs survey published in October 2015, the 50 largest U.S. defined benefit plans have assumed an average expected return of 7%. Many individual investors likely have similar return expectations built into their financial plans.
- Market returns have lagged long-term averages over the last decade.
For example, a hypothetical balanced index portfolio composed of 60% MSCI World Index/40% Bloomberg Barclays Aggregate U.S. Bond Index had a 10-year annualized return of 5.50% as of 10/31/2016. That means that, over the past 10 years, a completely passive portfolio would have been hard pressed to achieve that 7% return so many investors expect.
What does the future look like?
No one can precisely predict the path markets will take. But, with major equity markets at, or near, all-time highs and interest rates around the world at historically low levels, the next 10 years are likely to be equally – and perhaps even more – challenging for many investors. As of June 30, 2016, Russell Investments’ forecasts suggest that a hypothetical 60% global equities/40% U.S. bonds portfolio may have an annualized return of 4.78% over the next 10-years. Even if that return was generously rounded up to 5% – for illustrative and simplicity purposes – 5% is not 7%.
So, how can investors potentially move from a 5% to a 7% expected return?
The 3 rules of the low-return imperative
Aside from attempting to win the lottery, investors generally can attempt to increase the value of their nest egg through a combination of saving more, spending less or finding higher return opportunities. Of course, these choices are not always easy: Saving more effectively means lowering the current standard of living; spending less means either having a shorter retirement or a lower standard of living in retirement; pursuing a higher return can mean contemplating investment strategies that may be beyond the investor’s risk comfort zone.
Many investors are currently focusing on reducing fees as a way to potentially increase the actual performance received. However, prioritizing fees can cause investors to rotate out of actively managed investments into passive ones – thereby decreasing the likelihood of achieving a greater than the estimated 5% index-based return. A passive portfolio may make that 5% expected market return more “certain” than an active portfolio – but 5% is not 7%.
In our view at Russell Investments, this challenging market environment creates a very simple low-return imperative for investors:
So how might an investor earn incremental return to help close the gap between the expected 5% passive return and 7% required return? A skilled investor could potentially generate net of fee performance above the passive index by:
- selecting above average active managers
- maintaining targeted exposures to investment factors (for instance value, momentum, quality, low volatility)
- dynamically adjusting the portfolio’s asset allocation
- judiciously applying leverage and illiquidity where appropriate.
Of course, these strategies add uncertainty and risks, but also offer the potential to get investors closer to their required return of 7%.
5% is not 7% – an investor example
Meet Bob. Bob is 45 years old, makes $100,000 a year and plans to retire in 20 years. His current nest egg is worth $155,000. Bob and his financial advisor have determined that Bob will need $40,000 per year in retirement – which, by their calculations, would require a $1,000,000 nest egg at retirement. If Bob saves 10% of his income for the next twenty years, and earns a 7% return on his portfolio, he will reach his $1,000,000 goal in twenty years. However, if his portfolio earns a 5% return, he will have only $741,000, which, at a 4% withdrawal rate, would generate an annual retirement income of only $29,640. In order to get the same expected retirement income, he would have to save $18,000 a year rather than $10,000.
Disclosures: These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.
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Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.
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Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.
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Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.
Barclays U.S. Aggregate Bond Index is an index, with income reinvested, generally representative of intermediate-term government bonds, investment grade corporate debt securities, and mortgage-backed securities.
MSCI World Index is a free float‐adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. The MSCI World Index consists of the following 23 developed market country indexes: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United States.
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