Unfortunately, for people intent on adhering to a conventional 60-40 portfolio (with 60% allocated to stocks and 40% allocated to bonds) or gambling for their returns by placing money primarily in stocks, future returns do not look promising. The projected returns are lower than most people anticipate for two primary reasons:

  • The stock market rally that has taken place over the past few years has dramatically increased the multiple that people are now paying for stocks, and unless this time is different, it has also had the effect of reducing today's future return potential.
  • Current profit margins have expanded to a level that is well above their long-term average. Unless this time is different, a return to a more normal level will serve as a drag on profits over the remainder of this decade.

But before we get into the basis for my projection, let's take a look at the three primary return-drivers that power stock market returns:

  1. Corporate earnings growth
  2. Investor sentiment
  3. Dividends

Corporate earnings growth's contribution to returns
Since 1900, earnings growth for companies in the S&P 500 (SNPINDEX:^GSPC) (and its predecessor indexes) has averaged 4.73%.

Unfortunately for future returns, however, today's profit margins are a fair amount above the longer-term average. Depending on the time period measured and the companies included in the measurement, a "normal" profit margin is approximately 7%, while today's profit margin on the S&P 500 is around 9.5%.

As a result, I believe profit margins are likely to decline to the longer-term average of 7% by year-end 2020. As profit margins revert toward their long-term average, earnings growth will be subdued. To expect anything different is betting against the odds. The result is that corporate profits on the S&P 500 are likely to grow at a 5.53% annual rate.

Investor sentiment's contribution to returns

Investor sentiment is the dominant return-driver for stocks during periods of less than 20 years. Perhaps surprisingly, today, less than five years after the dramatic losses suffered by the world's stock markets during the financial crisis, investor sentiment is approaching historical highs. This is evident in a variety of indicators, such as investor surveys and stock fund inflows. But the measure we use, which confirms the optimism exhibited by these other measures, is the cyclically adjusted price-to-earnings ratio, or CAPE.

CAPE was popularized by Robert Shiller in his book Irrational Exuberance and compares the S&P 500's current price to the 10-year average of earnings. Over the past 114 years, CAPE has averaged 16.45. As of year-end 2013, due to the strong stock market rally of the past few years, CAPE has inflated to 25.09.

Unless this time is different, to believe that CAPE will remain at a new "permanently high plateau" is to bet against the odds. Over the remainder of this decade CAPE is more likely to revert to its long-term average. The result is likely to be an annual drag of -5.85% on stock market appreciation.

Dividends' contribution to returns
The dividend yield on the S&P 500 at year-end 2013 was approximately 1.91%. This represents a dividend payout ratio of 37%. This payout ratio is quite a bit lower than the 114-year average of 59%. If the payout ratio reverts to its long-term average, this will boost the dividend yield over the remainder of this decade. As a result of this -- and assuming that dividends compound this effect while increasing along with corporate profits -- I project that dividends will add 2.62% to annual returns between 2013 and the end of 2020.

Calculating the S&P 500 total return
We're now left with a calculation to determine the projected average annual return for the S&P total return index between year-end 2013 and year-end 2020.

This is the sum of the contribution from each of the three return drivers:

Sum Of Contributions Large

This performance is dramatically lower than what conventional investment wisdom has led people to expect. To expect a different result from what is shown here is to insist that "this time is different."

Bonds' contribution to returns
The yield on the Barclays Aggregate Bond Index, represented by the iShares Barclays Aggregate Bond (NYSEMKT:AGG) ETF, is historically predictive of total bond returns over the following five to 10 years. Given that the iShares ETF currently yields 2.32%, one can reasonably assume that the return of bonds through the remainder of this decade will be similar. To believe otherwise would be to believe that "this time is different."

Calculating the return on the 60-40 portfolio
In summary, based on the above straightforward analysis, from year-end 2013 through year-end 2020, we can expect the following return from a conventional 60-40 portfolio:

Projected Return Large

This is obviously much lower than what people have come to expect from a conventionally diversified portfolio. It is also likely insufficient to meet most people's financial needs.

But this is not a unique situation. Conventional investment wisdom has always encouraged gambling, rather than investing. Due to its reliance on just four return drivers, the conventional 60-40 portfolio has never provided true portfolio diversification and has always exposed people to unnecessary risks relative to the potential return. When those four return drivers underperform, as is indicated by the projections in this article, performance will suffer, but the risks remain. The dramatic losses in 2001 and 2008 should serve as a warning. They are not exceptions.

But there is a better way.

Increasing returns and reducing risk with return-driver-based investing
Portfolio diversification is the one true "free lunch" of investing, where you can achieve both greater returns and less risk, but true portfolio diversification can only be obtained by diversifying your portfolio across multiple return-drivers.

Mike Dever has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.