The average interest rate for savings accounts is 0.06%.
National home prices just reported their highest one-year gain in history.
The U.S. stock market is up ~700% since March 2009.
When everything seems risky and overbought, what do retirement savers do? How do you earn a healthy 7-8% return over the next 10-20 years?
I break it all down in this week’s episode.
How to Listen to Today’s Episode:
Episode Links & Resources:
- 👉 Get Your One-Time Retirement Plan
- Pension Funds Pile on Risk Just to Get a Reasonable Return [WSJ]
- Rolling the Dice 7.5% Returns [Callan]
- Global Investor Study [Schroder’s]
- Historical Cape Ratios by Country [Barclays]
- Future Expected Return Projections
How to Earn a 7% Return in Today's Environment
Taylor Schulte: Welcome to the Stay Wealthy Podcast. I'm your host Taylor Schulte, and today I'm talking about how to earn a healthy 7% rate of return on your money in this difficult environment, the average interest rate for savings accounts is 0.06%. National home prices just reported their highest one-year gain in history. The US stock market is up almost 700% since March of 2009. And then you have things like cryptocurrency. Bitcoin is up over 7000% in the last five years when everything seems risky and overbought.
How do retirement savers invest their money if they're hoping to earn a healthy seven to 8% rate of return on their investments over, let's say the next 10 to 20 years? I was recently asked this question by stay wealthy listener Robert G, and I thought I would expand on my answer here on the show so everyone could benefit before I do.
As always, you can grab the links and resources for this episode by going to youstaywealthy.com/127.
So before I put some real numbers to all of this, one simple exercise to start thinking about the current environment and, and what it might take to earn a 7% rate of return is to rewind back to, let's call it the, the early nineties to the early 2000s before the financial crisis hit. You might remember that during that timeframe, cash in the bank was paying you anywhere from three to 6% depending on what interest rates were doing that year.
Let's keep it simple and say you were earning about 5% on your cash during that time period. Well, in that scenario, you didn't have to take much risk or look very far in order to stack on an additional 2% of return to achieve that healthy 7% rate of return on your total investment portfolio. You could keep most of it in cash and treasuries and sprinkle in a few blue chip stocks and you're there when cash. A riskless asset is paying 5%, earning seven to even 10% rates of return feel pretty easy and attainable.
But when cash is paying nothing, you have to take an immense amount of risk in order to go out and get a 7% rate of return. Literally, all of your return has to come from risky assets. And yes it's been fairly easy up to this point over the last 10 years, you could have thrown a dart at pretty much any asset class and done pretty well.
But if we're being smart, prudent investors and thinking objectively about where we are today, right now, I think we can all agree that it's hard to expect things to continue to be this easy for the next 10 or more years given some of the numbers that I shared at the top of the show.
And to be clear, I'm not suggesting that the market is going to collapse, and you should take all of your money out of stocks and input it under the mattress. My goal with today's discussion is simply to set proper expectations around risk and return so you're properly positioned and prepared for the next 10 plus years, which for most of you listening is being spent in retirement, a time when we need safety and preservation of capital, but also a healthy rate of return so we don't outlive our money.
If you listen to the retirement income series last month, you know how much a healthy rate of return means to maintaining your retirement paycheck. The problem is, American investors in particular are the most optimistic about future returns, expecting an average of 13.2% total annual returns over the next five years. According to the recent Schroeder Global Investor study, expectations are way out of whack with reality, which is a recipe for trouble.
Another way to frame the current environment and bring to life how much risk we are being forced to take is to actually go back in time to see what sort of asset allocation you've actually needed to earn that healthy 7% rate of return compared to what might be needed today.
A quick note before I do that to help quantify risk, I'm going to reference standard deviation, and all you need to know about the standard deviation of an investment for today's conversation is that if it's a high percentage, let's say 15 to 20%, it would be considered risky. And if the standard deviation is a low percentage, let's say below 10%, it's a less risky investment.
For example, an S&P 500 index fund, like SPY, which is com comprised of all US stocks, has a 15-year standard deviation of about 17%. A safe US Treasury index fund is closer to three or 4%. So with that in mind, if we go back to 1995, we could have achieved a nominal return of 7.5% by putting 100% of our portfolio in bonds.
And this is according to a study done by Callen Associates, and the standard deviation of that bond index that was being used in 1995 was a mere 6%. In other words, you didn't have to take much risk at all to go out and snag seven and a half percent. You took about one third of the risk of the US stock market to do it.
Now, fast forward to 2005 and things got a little bit trickier. You needed 52% in bonds and 48% in a handful of different stock asset classes, including US Stocks, international and REITs. In order to get that same 7.5% rate of return, the portfolio as measured by Calen Associates as part of this study, had a standard deviation of about 9%.
So you had to reach for a little more risk in 2005 to get your respectable rate of return that you were looking for, but, but not much. Then in 2015, things started to get really interesting to get your 7.5% percent rate of return. You were looking at 12% in bonds and 88% in global stocks. And the standard deviation of that portfolio being measured in this study was 17%, which by most measures would be considered risky.
The article, which I'll link to in the show notes was written in 2016, and the first sentence sums up the environment at that time in four words by saying bigger gambles lower returns. Now, you might be saying to yourself, well, the authors were completely wrong. The market kept on going up and I had no issues earning a healthy return over the last five years. Didn't feel like I had to take much risk at all.
And you would be correct by saying that the S&P 500 is up about 140% since that article was written in 2016, which I'd argue means it's even more important to understand the risks that you're currently taking and the risk you'll likely need to take over the next 10 to 20 years to continue earning that healthy rate of return.
I think it was Meb Faber who recently summed it up well by saying, and I'm paraphrasing in my own words here, that the US stock market can of course, continue to go up and valuations continue, can continue to go up into even higher extremes. Just know that if that happens, you're essentially pulling future returns into the present, that higher valuations simply mean lower future expected returns. Kind of like China, when their cape ratio a popular valuation metric got up to 50 or 60 in 2007, and then after that, experienced a flat stock market for the next 10 years.
By the way, this works the other way around too, if the US stock market drops 30 to 40% and valuations come down, then you would expect higher future returns. Maybe not immediately, but over long periods of time, lower valuations would indicate higher future returns.
So again, yes, the broad US stock market continued charging upwards, but remember that you're just pulling future returns into the present if that happens, which will lower future expected returns. With all that information in our hands, what does one do to put themselves in the best possible position to continue earning a healthy rate of return in retirement without taking an unreasonable amount of risk and exposing themselves and their retirement plan to catastrophic losses?
To answer that question, we first have to revisit some of what I talked about in my retirement investing series from September of last year, and that is that the US stock market and all, all stock markets has multiple layers, more layers than the news headlines might lead you to believe that the media often references the S&P 500, which is an index that tracks the largest 500 companies in the US.
They reference the S&P 500 to share how good or bad the current market is doing. If you own an S&P 500 index fund, it's important to know that the larger a company in that index gets the more of an allocation you have to that company.
In other words, you have a higher and higher allocation to companies that are getting larger and larger in becoming more and more successful, which is quite the opposite from the old adage. Buy low, sell high or value-based investing where you aim to buy companies when they're cheap and hold them until until they're expensive.
You're literally doing the opposite in a plain vanilla S&P 500 index fund. The bigger a company gets, the more you buy and end up owning in your S&P 500 index fund. The technical term for this is market cap waiting.
S&P 500 index funds like Vanguard's VOO fund are weighted by market cap. So companies with larger market capitalization get a higher allocation. For example, the top 10 holdings in the Vanguard S&P 500 index fund make up 30% of the entire fund with names like Apple, Microsoft, and Google at the very top.
If you're a longtime listener, you know that I'm a huge fan of low-cost passive index fund investing, but I'm not a fan of market cap waiting, which is all too common waiting a portfolio instead based on valuation metrics, i.e. having a larger allocation to companies that are cheap or undervalued. profitability and size has historically helped to reduce risk and improve returns. Also, expanding your portfolio and investing overseas is a way to improve diversification and returns and also help mitigate risk investing in developed international stocks.
And emerging markets currently have lower valuations than the US market, i.e. higher expected future returns. While it's okay to have a home country bias, US investors currently have about 80% of their stock allocations invested in US stocks, which I'd argue is exposing them to more risk than they might be aware of. Taking a more prudent academic approach to investing, avoiding putting all of your investments in market cap weighted index funds because they do have some benefits.
So it's okay to hold some and investing globally are ways to help combat this tricky environment and earn a healthy future rate of return. To help illustrate how taking a more prudent approach might help you better earn a higher expected future return. Let's quickly look at Vanguard's recently released return expectations for all the different asset classes, and I'll link to this in the show notes.
So the 10-year annualized return projection for US growth stocks, according to Vanguard, is negative half of a percent to 1.5% per year. However, the projection for US value stocks is between three and a half percent and five point a half percent per year, and the projection for international stocks is five and half percent to seven and a half percent per year for what it's worth, most 10 year annualized bond projections from Vanguard are, are between 1% and 3% per year depending on the, the credit quality of the bonds you might own.
Remember, bonds are fairly easy to predict. The starting yield is a pretty good indicator of its future returns. Now, these projections are about the future and nobody has a crystal ball, not even Vanguard, but it helps to illustrate how investors like you and me, might begin thinking about where returns are gonna come from in the next 10 or more years.
So going back to where we started today's show, what does it take to earn a 7% rate of return on average over the next 10 plus years? Well, according to Vanguard, it's gonna take investing in 100% international stocks, which by their projection will carry a median standard deviation of about 19%.
In other words, you'll have to take a lot of risk to get there just for fun and the chance you find it helpful. Other large financial institutions publish similar future return expectations, most of which, like Vanguard are based on current valuation metrics, earnings growth and inflation expectations, not necessarily a crystal ball that they pretend to have.
Schwab is quite optimistic expecting 6.6% annualized total returns for US. Large-cap stocks still much lower than the long-term historical average of 10%, but much higher than Vanguard. They also expect 7.1% annualized returns for small-cap US stocks and six point a half percent for international.
JP Morgan is expecting 4% returns from US stocks, five to 6% from international, and 7% from emerging markets. And Morningstar is the least optimistic, expecting a negative 0.1% from US stocks annually on average for the next 10 to 15 years, and about four and a half percent from international stocks.
While all these research arms and financial institutions have slightly different expectations, the one common conclusion is that international stocks appear to be the most undervalued and therefore have the highest future returns or future expected returns. Small-cap stocks and value stocks, while not specifically named by each of these companies, also have lower current valuations by a lot of the different metrics.
Therefore one could argue also have higher future expected returns versus your broad-based index funds that are market cap weighted or large-cap US growth stocks, which have done very, very well in recent time periods.
There are three big takeaways that I want to end with here. Number one is it's going to take a lot more risk today than it did in 1995 or even 2005 in order to achieve a healthy average annual 7% rate of return going forward.
Number two, if the broad market indexes continue to charge upwards with little volatility, which could very well happen, just know that we are pulling future returns into the present and it will just make it that much trickier to expect healthy, consistent returns going forward from there.
And then number three, the market is not the S&P 500 or the Dow Jones Industrial average. When you hear someone say that the market is overvalued, ask them which market because there are countries, asset classes, sectors, and individual companies that by most measures appear to be undervalued or even just less overbought than these broad market indexes. Diversification and prudent evidence-based academic approaches to investing have never been more important than they are today.
For the links and resources mentioned, head over to youstaywealthy.com/127.
Thank you as always for listening, and I will see you back here next week.
Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.