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With Tuesday’s Federal Reserve announcement, it’s time for investors to ratchet down their equity market return expectations. With the Fed holding rates at or near zero, it looks like we have at least another two years of muted returns to muddle through.
Conventional wisdom suggests that investors will look for higher returns – they’ll abandon money market funds and the bond market and pour their money into the equity markets.
No doubt this trend (which has been underway for some time) will continue, but we think that investors will ultimately be disappointed with their returns over time.
Equities have become the savings vehicle of choice for many investors, and our experience tells us that when everyone is chasing the same trade, they’ll effectively drive down returns.
Look at how your equity investments have fared over the past three, five, or 10 years and then ask yourself what your investment return assumptions were when you originally made the investments. Not a pretty picture.
The positive case for equities today is that, unlike 2008, our banking system isn’t teetering on the brink on failure. But today, among other issues, we need to contend with the problems evolving in Europe, which are outside of Ben Bernanke’s jurisdiction.
Developed economies, representing nearly half of our corporate earnings, are teetering on the brink of failure.
While returns will be muted, volatility will remain high.
So if you’re nimble enough to trade in and out of the market and capture volatility, then you may be able to realise higher returns, and hats off to you. But most of us aren’t attempting to time the market.
The real problem for the average equity investor in a low return environment is that their portfolios will swing in and out of negative territory with market volatility.
While their investment managers will attempt to tell them how well they are doing on a relative basis, real world investors don’t react well when staring at a statement showing absolute losses. This inevitability leads to poor investment decisions.
It’s not just the retail investor with unrealistic expectations. I talk to a lot of investment managers on a regular basis and I always make a point of asking them what they’re using for equity return assumptions in their budgets (investment returns are a critical part of their business models). They all view the current low return environment as some sort of “event” that will soon pass. While their outlook for the current year may be somewhat realistic, their out year assumptions reflect their beliefs that the returns of the good old days are just around the corner. Keep in mind that, notwithstanding their fiduciary duty, investment managers get paid to push equity related products and services – buyer beware.
In this seemingly permanent state of low interest rates, we caution investors that moving money from a different asset class (cash or bonds) to pick up incremental return in the equity market dramatically changes a portfolio’s risk profile. Instead, investors must adjust their expectations to the new low return environment. As we see it, equity market risks have gone up, while rewards have gone down.