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4% Is All You Get! Why Stock Investors Could Be in for Disappointment

By Alex Dumortier, CFA - Oct 23, 2015 at 1:20PM

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Vanguard's Jack Bogle explains why his expected return for stocks over the next decade is just 4% annualized.


Farmer in despair over the Depression in 1932. Source: U.S. National Archives and Records Administration.

In the wake of well-received earnings from several megacap technology companies, U.S. stocks look like they will close out the week on a positive note. The Dow Jones Industrial Average ( ^DJI ) and the S&P 500 ( ^GSPC 1.18% ) are up 0.57% and 0.78%, respectively, at 1 p.m. EDT.

From daily returns to next-decade returns (which are easier to forecast), what annualized return, inclusive of dividends, do you expect to earn on the equity portion of your investment portfolio over the next 10 years? For context, the long-term historical total return on U.S. stocks is roughly 9.5% per annum.

Jack Bogle, a towering figure in the investment business, who is no perma-bear, thinks stock returns could be less than half that figure.

The Bogleheads Conference took place in Philadelphia in the middle of this month. The conference is named in honor of Jack Bogle, the founder of index investing powerhouse Vanguard Group. Bogle was in attendance; research company Morningstar asked him for his expectations for asset class returns over the next decade.

In answering, Bogle carefully explained his methodology (which is sometimes referred to as "Bogle's method") and his assumptions (my emphasis):

Well, for U.S. equities, I have a simple formula, as you know. It says divide it up into two segments: One is investment return, and the other is speculative return. Investment return is the present dividend yield -- a little over 2% -- and the earnings growth that follows.

And I think it's going to be a little bit of a push for that earnings growth to get to 6% -- but I'm going to use 6%. So, that would be an 8% investment return on stocks.

In other words, reasoning solely on the basis of earnings and dividends, 8% is an aggressive baseline forecast (we'll see why I label it aggressive below).

Fine, but what is this "speculative return," and how does it alter the 8% forecast? Here's Bogle (my emphasis):

Now, when you get to speculative return, that's whether the P/E ratio go up and pump that up or go down and deflate it. And I look at the P/E from the perspective of past reported earnings -- GAAP earnings, as we say it -- at being about 20 times. Wall Street looks at it through forward earnings, but forward expected earnings. So, they're using about a 17 P/E, and I'm using about a 20. I'm going to stick to my guns. To go from 20 to 17, that would be about a 2% annual loss.

Add the investment return to the speculative return, and you're left with an expected return for stocks of 8% + (-2%) = 6%. In fact, Bogle thinks that's the best we should expect, but his baseline expectation is lower:

I think the best thing we can expect [...] is that 8%, [or 2% dividend yield and 6% earnings growth]. But in fact, I don't think earnings growth is going to be that good, and so I think the P/E could easily get to a more normal long-term range of 15. So, that would be 3% from that number. So, you'd have an investment return of 2% and 5% for 7%, minus 3% for speculative return. That would be 4% for stocks, and that's not a very good number.

Not a very good number, indeed! Keep in mind that this is before the punitive effect of inflation. Assuming a 2% inflation rate, you're left with a 2% real return.

Four percent annually is Bogle's expected return. Now, stock returns are volatile, so it's certainly possible actual returns will turn out to be higher, perhaps significantly so (it could also be lower, naturally). Returns volatility can swamp the expected return, even over a 10-year period.

Still, the question is what assumptions you wish to make in planning your financial future. In that regard, an expected return is not a bad place to start. If you take Bogle's forecast seriously, two conclusions are possible.

First, many investors ought to adjust their expectations downwards, with all that that implies.

Second, investors who want to earn a return in excess of roughly 5% ought to be allocating money to active managers over index funds, or perhaps to foreign stocks (although Bogle would probably counsel against both of these).

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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S&P 500 Index - Price Return (USD)
^GSPC
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