Should you expect lower returns from stocks?

Expected returns from stocks are important in investment planning; using the wrong numbers can mean trouble for a portfolio. A new study helps shed some light on the expected returns of stocks, and it's not good news for people expecting the high returns to continue.

The study, "The Expected Real Return to Equity," used a model capturing the present value relationship linking dividends, earnings, and investment-to-market values via expected returns. The model produced an estimated expected real return to stocks ranging from 4 percent to 5.5 percent, quite a bit lower than the historical real return of around 7 percent. In addition, the analysis indicates that expected returns have declined by about 2 percentage points over the past 40 years. (It should be noted that the study covered the period 1966 through 2009 and excluded financial firms and regulated utilities.)

This estimate of the future real return to stocks is consistent with the estimates made by professors Gene Fama and Ken French in their 2002 study, "The Equity Premium," as well as the estimates from several other studies over the last several years.

The importance of a study such as this one comes about because many investors, both individual and institutional, use backward-looking indicators (that is, historical returns) to estimate future returns. If historical returns portray too rosy a picture, severe problems can result. For example, pension plans will be underfunded if they expect stocks to provide their historical real return of about 7 percent, but forward-looking measures estimate the real return at just 4 percent. Individuals will have to save more for retirement and/or plan on working longer. In addition, risk averse investors who expect stocks to provide a 7 percent real return might allocate a lower percentage to stocks than if the expected real return was just 4 percent.

Why have expected returns fallen? One explanation offered is that the Great Depression led to an increase in the market price of risk that has slowly dissipated over time. Another is that increased participation in the stock market might have lowered the expected returns to stocks.

Financial economists seem to agree that expected stock returns are quite a bit lower than historical returns. This has serious implications for investors who shouldn't build plans based on backward-looking measures, which seem likely to leave them well short of achieving their financial goals. If you've been using historical returns in your plan, you should reconsider before it's too late to make appropriate changes that would provide you with a more reasonable chance of achieving your financial goals.