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I saw a cartoon in a research report the other day that really hit the mark. It showed an older man in a suit smoking a cigar. He's looking skeptically at a smiling middle-aged money manager holding up a sheet of paper. The money manager exclaims: "We didn't underperform. You overexpected."
Hey, that's Wall Street's favorite message these days, considering that the stock market has risen by 1.6% so far this year, compared with a 28% average annual gain over the previous five years. But the cartoon addresses a far more serious dilemma: What sort of long-term return should investors expect from the equities they're buying for their retirement years? The stock market has had a record run, with the Standard & Poor's 500-stock index returning 18% over the past two decades, well above the 11% average return since 1926. These gains have helped push household wealth to record levels. But the risk of disappointing returns is real. For instance, following the great bull market of 1949 to 1968, the average stock fell by 75% over the following six years. Even more striking, the Dow Jones industrial average at the end of 1964 stood at 874.12 and at 875 by the end of 1981.
Investors are right to worry about future returns, since the risk of declining living standards in retirement looms large. The reason: Employers have heartily embraced retirement-savings plans, such as 401(k)s in the private sector and 403(b)s among nonprofits. They expect their employees to take responsibility for funding their retirement plan, and the employee absorbs all the investment risk. Whether workers end up spending their golden years in a condo by the ocean or in a trailer park off a highway partly depends on the stock market's long-run performance.
TALE FOR THE GRANDKIDS. Of course, uncertainty is the essence of investing, and forecasting is a hazardous business. But a review of the economic literature related to long-term returns seems to suggest that a nominal 9% to 12% return is a reasonable assumption, or a 6% to 9% return after taking inflation into account. For example, Roger Ibbotson, a finance professor at Yale University and founder of investment-consulting firm Ibbotson Associates, forecasts a nominal median return of 11.6% for large-capitalization stocks between 1999 and 2025 (table). (His inflation forecast over that same time period is 3.1%.) That's in line with historic U.S. stock market returns.
Steve Leuthold, a Minneapolis-based money manager and well-known market historian, offers a more bearish perspective. He recently completed the last installment of a three-part study into long-term stock returns with colleague Andy Engel. Taken together, the studies emphasize long periods of disappointing stock market performance, especially for those investors who start buying during bull-market peaks. Still, despite accumulating evidence that there will be hair-raising moments along the way, Leuthold's work does suggest that a nominal 9% return is a realistic assumption for today's savers.
To be sure, those return figures are half or less than half of the heady gains of the past 20 years -- never mind the past five. It looks like the stock market of the late '90s will be a good story to tell the grandchildren. Nevertheless, stocks should still offer superior returns to the main investment alternatives, such as bonds and cash. And equities should remain a core holding in any portfolio held for the long haul.
BRAIN POWER. But let's think outside the box for a moment: In the New Economy, another investment may offer even better long-term returns than stocks. Skill and knowledge -- what economists call human capital -- are increasingly valuable in the Information Age. Economists estimate that the lifetime rate of return from investing in a four-year college degree is between 10% and 15% annually -- and the figure could be higher today. That return is more than competitive with the average return on stocks. And it's not just college: Training, industry seminars, and other lifelong-learning programs also pay off. Learning new skills and keeping current with advances in a profession may be the best investment of all, especially as more and more people find ways to remain attached to work during their elder years.
In other words, investing in education may be another "asset class" to add to the traditional investment mix of stocks, bonds, real estate, and cash.
Roger Ibbotson's Forecast, 1999 -- 2025
Total Return of Small Cap Stocks: 12.5%
Total Return of Large Cap Stocks: 11.6%
Total Return of Government Bonds: 5.4%
Total Return of Treasury Bills: 4.5%
Inflation: 3.1%
DATA: Ibbotson Associates
Farrell is contributing economics editor for Business Week. His Sound Money radio commentaries are broadcast on Saturdays in nearly 200 markets nationwide Edited by Douglas Harbrecht
Copyright 2000, by The McGraw-Hill Companies Inc. All rights reserved.
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