How can I get an 8% return on my investments?
by Walter Updegrave @CNNMoney
I’d like to earn a steady 8% a year on my retirement portfolio. What investments do you recommend that can deliver that return? --M. A.
My mother’s automatic response whenever I asked her for something she considered unreasonable (like two bucks for a movie) was “People in hell want ice water.” Translation: Just because you want something doesn’t mean you can have it.
I could say the same about your desire to earn a reliable 8% a year on your retirement portfolio. It would be wonderful if I could point you to investments that will generate a steady 8% annually. But that’s just not realistic in today’s market environment. People argue about why yields and projected returns are so low these days. (To see the diversity of views on that discussion, you can check out former Federal Reserve chairman Ben Bernanke’s blog.) But given today’s low interest rates and relatively lofty stock valuations, the consensus among investment pros is that we’re in for an extended period of low returns.
A recently released long-term forecast for stock and bond returns from investment adviser and ETF guru Rick Ferri estimates annualized returns over the next few decades will come in at 7% or so for large-company stocks and 4% or so for 10-year Treasury bonds, assuming 2% inflation. Other prognosticators may differ a bit in their outlook. But most investment pros expect returns in the years ahead to come in well below the long-term historical annualized returns reported in the Ibbotson Stocks, Bonds, Bills, Inflation 2015 Yearbook: 10.1% for large-company stocks and 5.3% for intermediate-term government bonds.
It’s important to remember, of course, that we’re talking about projections here, and projections quite often miss the mark. And even if this one is spot on, there will still be lots of variation around it. Stock and bond returns fluctuate up and down quite a bit, so some years you’ll do better than the average, some years worse. There can also be lots of variation depending on what type of stocks and bonds you own. Small stocks and emerging market shares should do a little better over the long-run, as should corporate bonds. But those higher returns, if they materialize at all, come with more risk and greater ups and downs.
So what does this all mean for retirement investors?
Well, if you’re saving for a retirement that’s still off in the future, the possibility of lower future returns means you should plan on saving more. For example, a 35-year-old who earns $50,000 a year, receives 2% annual raises and already has $50,000 saved in a 401(k) or similar retirement account would have to contribute about 11% of salary over the next 30 years to have $1 million at retirement, assuming a 7% annual return (8% minus 1% a year in expenses).
But if stock and bond annualized returns come in close to a projected 7% and 4%, a 35-year-old who invests in a diversified mix of 70% stocks-30% bonds might see annual returns closer to 5% annually (6% for a 70-30 blend of stocks and bonds minus 1% in expenses). Which means he might have to save almost 20% a year to end up with $1 million at age 65. If coming up with those extra savings is just too big a burden – which is likely to be true for many people – working a few more years can help.
If you’re already retired, the prospect of lower investment returns means spending more carefully, which for most people translates to a lower withdrawal rate when tapping your nest egg. Back in the heyday of robust stock and bond returns, retirees who followed the 4% rule had a 90% or so chance that their savings would last at least 30 years. But with projected diminished returns, the chance of your nest egg lasting that long might be 80% or less, leading some retirement experts to suggest that an initial withdrawal rate of 3% or less might more appropriate today.
Given those unappetizing choices – save more before retirement, spend less during – many investors may be tempted to go a third route: Shoot for higher returns, whatever it takes. That would be a mistake. Sure, you may be able to tweak returns around the edges by investing more heavily in stocks or tilting your portfolio more toward small caps or emerging markets. But the more you do that, the more volatile your portfolio becomes and the more your savings will get hammered during market meltdowns.
A better approach: create a broadly diversified portfolio of stocks and bonds that makes sense given your tolerance for risk, your time horizon and investment goals, and do the best you can with the returns that strategy generates.
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That said, there is a way you can boost returns without taking on additional risk: stick to low-cost broadly diversified index funds and ETFs. For example, a recent Morningstar fee study showed that the asset-weighted expense ratio for all actively managed mutual funds is roughly 0.80% compared with about 0.20% for index funds and ETFs. And you can even find many index funds with annual expenses of 0.10% or less. There’s no guarantee that every basis point you save in expenses will translate to a basis point of higher return, but funds with lower expenses do tend to outperform their high-expense counterparts.
And make no mistake that the extra return you’re likely to get by reducing investment costs can dramatically improve your retirement prospects. Remember how our hypothetical 35-year-old above would have to ratchet up his savings rate to almost 20% given lower projected returns? Well, if he managed to get his annual investment expenses down to 0.25% by sticking to low-fee index funds and ETFs, that annual savings burden would drop to a more doable 15% or so.
Ultimately, there’s not much you can do about the level of returns the financial markets deliver. So rather than falling for a pitch for some magical investment that purports to offer higher returns with no additional risk – or pumping up your stock holdings to try to boost returns – you’re better off focusing on the things over which you have at least some control: how much you save and spend, how you divvy up your savings between stocks and bonds and how much of your return you give up to investment expenses.