We are in an economic recovery, although for many people, it doesn't seem like one. Slow economic growth has investors wondering how long this bull market can last and when stronger growth will return... but what if the current market is as good as things are going to get for the next ten to twenty years?
The title of a recent report from the McKinsey Global Institute says it all: "Diminishing Returns: Why Investors May Need to Lower Their Expectations." The report suggests that inflation-adjusted returns of the last thirty years for the U.S. and Europe are the exception to the rule, and that investors need to lower their expectations for future returns.
The report cites four major factors that kept the last thirty years well above the 100-year average for returns: a sharp drop in inflation, a similar sharp drop in interest rates, favorable demographics and productivity gains fueling GDP growth, and exceptional corporate profit margins. Inflation and interest rates basically have nowhere to go but up. Productivity and employment are unlikely to rise at the same time, affecting consumer spending. Corporate profits should be squeezed as a result.
The report explores two scenarios for the next thirty years: a low-growth scenario with returns on equities around 4-5% (down from 7.9% from 1985-2014) and fixed-income returns between 0-1% (compared to 5.0% from 1985-2014), and a recovery scenario with equity returns from 5.5-6.5% and fixed-income returns from 1-2%. For Americans entering their thirties, this means approximately 80% more savings or an additional seven years of work to acquire the same nest egg as the previous generation.
How do you navigate this new investment environment? Here are a few ways to adapt and thrive.
1. Don't Be Afraid to Invest – Returns may be below previous levels, but low returns are better than no returns at all. In a way, a period of lower returns represents opportunity for younger investors because it allows them to buy more stocks at a lower price and receive a larger payoff down the road. "Buy low and sell high" always works.
2. Re-evaluate Risk – A proper portfolio should balance risk depending on your needs at each point in your life. In the early years, more risk is necessary to maximize returns. If you can tolerate higher risk in the early years, shifting your portfolio further in that direction gives you the opportunity to increase your returns while you have time to recover from any market drops.
3. Use Defensive Stocks Wisely – Defensive stocks are stocks that are generally stable, represent necessities, and are independent of the business cycle (such as utilities). Because of their inherent stability, they tend to outperform the market during down cycles.
4. Increase Savings – It's hard to beat cash reserves during difficult times. Carve out an increased segment of your budget to devote to savings. (If you don't have a budget at all, that's the place to start.) Don't be discouraged if you can't reach an 80% increase — few of us can. Save whatever extra money you can and build a savings mindset that gains momentum over time.
5. Consider Passive Investing – Passive investments in vehicles like no-load index funds can help you maximize returns by keeping your fees low and keep you from "overtrading" while attempting to time the market. In theory, active investment funds with a top-notch manager can earn higher returns in down markets, but there simply aren’t that many managers capable of beating passive funds on a regular basis.
6. Prioritize Spending/Limit Debt – An increase in savings can be neutralized by simultaneously accumulating too much debt. While mortgage debt is useful for building equity, be careful not to overextend yourself. Do not buy a larger and more expensive home than you need just because you can afford the payments. Do you really need a new car every few years? Analyze your spending closely, and you will be surprised to find out how quickly the small things add up — and how you can weed out unimportant purchases and still lead an enjoyable life.
Above all, take charge of your own retirement investments. Don't count on Social Security or pensions for the majority of your retirement income. Both programs are having fiscal difficulties in good times — just imagine what would happen in a long-term stagnant economy. Invest in 401(k)s, IRAs, and other investment vehicles to the extent you can afford them.
The McKinsey report may turn out to be wrong, but it is in your best interests to assume that it is right and plan accordingly.