Most people invest to achieve long-term financial objectives. Common long-term goals include saving for retirement, funding a child’s college education and transferring wealth to future generations after one has passed. Typically, these goals require an investment horizon of at least ten or twenty years. Since the horizon of most investors is long-term in nature it follows that what should matter to investors is the long-term expected rate of return from their investments. Short-term investment returns tend to dominate the conversation on Wall Street and in the financial news media, but they are of limited importance to anyone investing for the long term.
Although the future is uncertain, it is possible to reasonably estimate an investor’s expected long-term rate of return (for the sake of simplicity, let’s define the long-term in this discussion as the next ten years). This is because investment returns over the long-run are driven by fundamental economic and financial market variables which are quantifiable. Perhaps counterintuitively, investment returns over the short-term are much harder to estimate because market sentiment, which oscillates between optimistic and pessimistic, can override fundamentals over shorter periods of time.
While it is possible to have a good idea of the long-term rate of return an investor is likely to achieve, to be clear this is very different than saying it is possible to exactly estimate the future long-term rate of return. The best we can hope to achieve is to estimate future investment returns within a reasonable range of likely outcomes, while acknowledging that our estimates may prove incorrect.
To estimate an investor’s long-term expected rate of return, we first have to define an investor’s asset allocation, i.e. the mix of assets held in that investor’s portfolio. To simplify this exercise, assume that an investor holds only two assets: stocks (equities) and bonds (fixed income). Further, also assume that the investor holds 60% of their portfolio in stocks and 40% of their portfolio in bonds. This is the so-called 60%/40% stock-bond portfolio that has traditionally been one of the most common asset allocations held by individual investors. As such, we think it is an appropriate hypothetical portfolio to use in this exercise. With our asset allocation mix in hand, we can now proceed to estimate the long-term expected rate of return for both stocks and bonds. Let’s start with stocks.