We all want to know how stocks and bonds will perform next year and beyond. Unfortunately, forecasts typically give very tight ranges of returns — and often merely predict the past. That may partly explain why investors continue the pattern of buying high and selling low.

The Vanguard Capital Markets Model, which forecasts both returns and risks over the next 10 years, takes a more useful approach. Your clients might prefer to have more precise forecasts, but uncertainty is a reality.

This forecast may help you both design a better portfolio and explain its rationale to your clients. I spoke with Roger Aliaga-Diaz, a principal and senior economist in Vanguard’s Investment Strategy Group, about the model and its implications for investors.

The Vanguard Capital Markets Model’s estimated returns are based on 10,000 simulations. This Monte Carlo analysis runs not only variations of returns but also ranges of risk (standard deviation) and correlations among asset classes.

The “Range of Returns” and “Asset Class Correlations” tables on page below shows the forecast returns and ranges and the historical correlations.

EQUITY EXPECTATIONS

The first takeaway: Across the board, equities are expected to far outpace inflation, which is estimated at 2% annually. As the midpoint in the range of expectations, U.S. stocks are estimated to return 7.7% annually, while international stocks will yield 8.5%.

International stocks were seen as likely to outperform U.S. stocks for a few reasons, says Aliaga-Diaz: International valuations are more attractive and investors are compensated for taking on more risk. The annual standard deviation for international stocks was 20.9%, he points out, compared with 17.6% for U.S. stocks.

Within the bracket of outcomes that Vanguard believes have a 90% probability of occurring, U.S. stocks are shown as returning between a loss of 2% annually and a gain of a whopping 17.7%.

International stocks, by contrast, are seen as returning anywhere from a loss of 3.3% to a 21.1% annualized gain.

To put this in perspective: In 10 years, a $1 million investment in U.S. stocks could be worth anywhere from $820,000 to $5.1 million. And the same investment in international stocks could be worth anywhere from $710,000 to $6.8 million.

Not only is that range of returns incredibly large — and only somewhat helpful from a planning perspective — but Vanguard says there is a 10% probability that the actual return will land outside of these ranges. And the downside risk is even worse after you factor in inflation.

The bottom line, of course, is that equity investing is risky — any forecast asserting otherwise would be claiming to have precise (and, needless to say, impossible) foreknowledge of economies, geopolitical events and investor sentiment. Nonetheless, equities offer the best expectation for high future returns.

Clients should also understand the impact of expenses and emotions on these returns. Aliaga-Diaz notes that the projections are geometric asset class returns and don’t include costs, and that even the lowest-cost index funds have some fees. And clients need to stay the course. Even with the least-costly index funds, investors’ returns underperform fund returns — an indication that investors time the market poorly.

FIXED-INCOME INVESTMENTS

Bonds, of course, have lower expected returns with less risk. Vanguard predicts the aggregate bond index of investment-grade bonds will return 2.5% annually — just half a percentage point more than inflation.

The range is much tighter than for stocks, with the 90% confidence interval showing returns ranging between 1.2% and 3.9% annually. Translated again, this suggests that a $1 million investment would be worth anywhere between $1.13 million and $1.47 million after a decade.
Note that these returns are far below those of the last decade, when declining rates were good for bonds.

The narrow range of returns for bonds illustrates the role of high-quality bonds; they are more a store of money than a growth vehicle. Hedged international bonds offer similar expected returns and volatility.

Both of these bond classes have little credit risk; increasing credit risk increases correlation with stocks. For example, according to Morningstar, the average bond mutual fund — which is more likely to include bonds of lower credit quality — lost 8% in 2008 while Vanguard’s Total Bond ETF (BND), which follows the Barclays Capital Aggregate Bond Index, gained about 5.1%.

One more note on the inflation forecast: While 2% doesn’t sound unusual, extrapolating the downside shows about a 15% probability of sustained deflation over the next decade. Should that occur, the resulting scenario would be bad for stocks and great for longer-term U.S. government bonds.

CONSTRUCTING A PORTFOLIO

What matters most for clients, of course, are real (after inflation) returns. But to model the impact of inflation, we can’t just deduct two percentage points — because inflation impacts the returns of the asset classes.

The Vanguard model — run for a combination of U.S. and domestic equities, with various maturities of Treasuries and corporate fixed-income securities — looks at various weightings, from conservative to aggressive. The “Portfolio Implications: Real Returns” chart above shows the results.

Because high-quality bonds and equities have low correlation to each other, you’ll note the combined portfolios have less downside than the simple average of stocks and bonds.

The good news is that even a conservative portfolio of only 20% equities is forecast to outpace inflation by 1.7 percentage points annually. And it can still deliver a handsome return if results are high in the range of possible outcomes.

The takeaway here is that clients who have met their goals and have little need to take risk — even those who say they have a high risk tolerance — should consider a high concentration of high-quality bonds. (Think back to March 2009 and ask yourself if clients’ appetite for risk was in fact constant.)

A moderate portfolio of 60% equities is projected to outpace inflation by 4.2 percentage points annually.

An aggressive portfolio of 80% stocks does deliver an expected return of 5.4% annually, while the downside is only an extra annualized 0.7 percentage point loss relative to the moderate portfolio.
While this might argue for taking on more risk, few aggressive investors want to stay the course when markets melt down. By my calculations, that portfolio declined by about 31% in 2008; that’s more than two standard deviations away from the mean and should happen only once every 40 years.

HOW MUCH RISK?

Just looking at the numbers, one could conclude that the 80% equity portfolio isn’t that much riskier than the 20% equity portfolio. In real terms, the outcome at the bottom fifth percentile for the 80% equity portfolio loses about 31% of spending power, while the fifth-percentile result for the 20% equity portfolio loses about 22%.

But don’t forget that a fifth-percentile outcome doesn’t measure the so-called black swan event that many said happened in 2008.

What this means for your clients is certainly open for interpretation. This is perhaps the most comprehensive economic model I have reviewed, but even so, it is important to remember that this is only one model.

Vanguard predicts a most likely case of a 5.7% real annual returns for stocks, but other experts are more cautious. In his new book, Rational Expectations, William J. Bernstein predicts a 2% real return for large-cap stocks and 3% for small-cap stocks over the next decade. Rob Arnott, chairman of Research Affiliates, forecasts a 3% real return over the next decade.

My opinion is that the future is even more uncertain than the ranges shown in the Vanguard model — especially on the downside. And as I see it, the world is a less predictable place than ever before. 

Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for CBS MoneyWatch.com and has taught investing at three universities. Follow him on Twitter at @dull_investing.

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