Expecting 10% returns? It's time for a reality check

What sort of returns has the stock market delivered historically? And will the future look anything like the past?

We've all seen those rosy retirement projections based on earning 8 or 10 per cent annually. Well, we've got bad news for you: Those returns are almost certainly too optimistic, especially when one factors in fees, inflation and the self-defeating habits of many investors.

So in this edition of Investor Clinic, we'll try to come up with a more realistic projection. First, we'll look at what the stock market has returned in the past. Then we'll consult some brains that are much larger than ours to see what the future may have in store (Hint: You may want to stop fantasizing about that Porsche and start thinking Hyundai).

In his influential book, Stocks for the Long Run , Wharton finance professor Jeremy Siegel calculated that, from 1802 to 2006, the real (after inflation) return of U.S. stocks averaged 6.8 per cent annually, assuming all dividends were reinvested. While returns were remarkably stable when measured over many decades, performance swung wildly in shorter time periods.

The huge run in stocks at the end of the last decade, in particular, may have raised investor expectations to unreasonable levels.

"The bull market from 1982 through 1999 gave investors an extraordinary after-inflation return of 13.6 per cent per year, which is double the historical average," Mr. Siegel writes. "This constituted the greatest bull market in U.S. stock market history."

So if 13.6 per cent isn't realistic, what is?

William Bernstein, author of The Investor's Manifesto , says using historical returns to predict the market's future performance is fraught with peril. Instead, he uses a formula called the Gordon Equation, which states that the real expected return equals the dividend yield plus the real per share dividend growth rate.

The dividend yield on the S&P 500 is currently about 1.8 per cent, and per share dividends are growing at an inflation-adjusted rate of 1.5 per cent to 2 per cent, he says. That means the expected real return of the U.S. stock market is just 3.3 per cent to 3.8 per cent annually, or a nominal return of 6.3 per cent to 6.8 per cent, assuming inflation will average 3 per cent.

"You get the idea: Returns are going to be lower going forward," Mr. Bernstein says in an e-mail. The main reason is that, while real dividend growth rates have been stable, dividend yields have come down dramatically over the past several decades.

Using different methods, others have come to similar conclusions. Writing in the January/February 2010 edition of the Financial Analysts Journal, California Institute of Technology economics professor Bradford Cornell examined historical and projected growth rates in gross domestic product and earnings, which ultimately drive stock prices.

His conclusion: "Over the long run, investors should anticipate real returns on common stock to average no more than about 4 per cent."

For many investors, even that may be too optimistic. Why? The stock market is an emotional place, and people engage in counter-productive behaviour. They buy at market tops, and sell at market bottoms. They don't diversify properly. They pay hefty fees. As a result, they end up earning substantially less than benchmark returns.

According to financial services research firm Dalbar, equity mutual fund investors had average annual returns of just 1.87 per cent for the 20 years ended December 31, 2008. That compares with a total return - including reinvested dividends, and before adjusting for inflation - of 8.4 per cent for the S&P 500.

Investors can take steps to minimize costs and rein in emotional behaviour, but they can't control the stock market. Garth Rustand, executive director of the Investors-Aid Co-operative of Canada, says investors would be wise to lower their expectations.

"You and I have grown up in a long period, basically after the Second World War, of inflation. We've gotten used to steadily increasing prices and steadily increasing returns but I think that's over with," he said. Economic growth has slowed, unemployment is higher and wages are in many cases stagnant or falling.

For those reasons, investors shouldn't count on double-digit returns. "I think people who make 4 to 5 per cent [including inflation]are going to be pretty happy people," he said.