Your Complete Guide to Index Investing with Dan Bortolotti

Estimating Future Stock Returns

2017-12-02T21:36:52+00:00February 25th, 2013|Categories: Financial Planning, Research|Tags: |41 Comments

What are the long-term expected returns for stocks? That’s a fundamental question every investor needs to consider when deciding on an appropriate asset allocation. Unfortunately, it’s not a question anyone can answer with certainty—though there’s no shortage of gurus with opinions.

In a paper published last October, researchers at Vanguard examined 15 commonly used methods for forecasting stock returns to see how much predictive power they would have had in the past. These included price-to-earnings (P/E) ratios, dividend yield, earnings growth, economic fundamentals, and recent stock returns. And just for fun, they threw in a red herring: the trailing 10-year average rainfall in the US.

For each variable, the researchers set out to find whether it would have helped predict US stock returns during the 10 years that followed. Suppose, for example, you measured the trailing one-year dividend yield on stocks in 1950. How useful would that variable have been in explaining inflation-adjusted returns from 1951 through 1960? They repeated this for all the factors, in all rolling 10-year periods starting in 1926.

Turns out about half the variables were entirely useless: “Many popular signals have had a lower correlation with the future real return than rainfall,” the researchers wrote. The biggest flops included consensus GDP growth, consensus earnings growth, and corporate profit margins. The variables most effective at predicting future returns turned out to be trailing one-year P/E and cyclically adjusted trailing 10-year P/E, commonly known as the Shiller CAPE ratio. This latter variable explained about 43% of the subsequent decade’s stock returns.

Peeking under the CAPE

The Shiller CAPE ratio is named for Robert Shiller, professor of economics at Yale and author of several books including Irrational Exuberance. Instead of trailing one-year earnings, Shiller’s ratio uses the average annual earnings of companies over the past 10 years, adjusted for inflation. The idea is to smooth out the numbers over an entire business cycle.

The practical difficulty with using Shiller CAPE is the data are not easy to find unless you happen to have a Bloomberg terminal. But for a recent post on his blog, Justin Bender at PWL Capital (who knows a guy with a Bloomberg terminal) tracked down these numbers for Canadian, US, international and emerging markets. As of December, the data predict future real returns (after inflation) of 5.7% for Canada, 4.7% for the US, and 6.6% for international and emerging markets.

Following the advice of Larry Swedroe, Justin then adjusted the figures downward by 1% to account for “slippage” in earnings yield. Assuming an equity portfolio that’s one-third Canadian, one-third US, and one-third international/emerging, they now project a real return of 4.7%. If you assume 2% inflation going forward, that’s a nominal return of 6.7%.

For expected bond returns, it’s reasonable to simply look at the current yield to maturity of the DEX Universe Bond Index, and Justin used an estimate of 2.25% (nominal). Combining these two projections, here are the expected nominal returns for portfolios with various asset mixes:

Stocks 80% 70% 60% 50% 40% 30% 20%
Bonds 20% 30% 40% 50% 60% 70% 80%
Expected return 5.8% 5.4% 4.9% 4.5% 4.0% 3.6% 3.1%

Remember, these figures do not include costs. If you’re using ETFs, you likely need to subtract at least 0.50% for fund MERs, trading commissions, bid-ask spreads, withholding taxes, cash drag and other incidentals.

A framework for your plan

So what’s the takeaway message from this little exercise? Let’s be clear: any forecast of expected returns is only so useful. After all, even if Shiller CAPE was the most reliable variable in the Vanguard research, it still only explained about 43% of subsequent returns. “We feel it is important to stress that even conditioning on initial P/E ratios leaves approximately 60% of the historical variation in long-term real returns unexplained,” said the authors of the paper.

But these figures can be useful for managing expectations. In our DIY Investor Service, it’s not unusual for  clients to say they expect returns of 6% to 7% from a balanced portfolio. Current Shiller CAPE ratios and bond yields suggest that’s unlikely even from a portfolio of 80% stocks. Investors who are comfortable with a traditional 60/40 portfolio will likely need to save more (or spend less) than they bargained for.

The Vanguard researchers go out of their way to stress that long-term expected returns are a moving target, not “point forecasts.” They can be helpful as a framework for planning, but it’s not like you can do this at age 35 and expect your projections to be valid until you retire at 65. You need to revisit the numbers every few years to make any necessary course corrections to ensure you’re taking as much risk as you need, but no more.


  1. gsp February 25, 2013 at 8:35 am

    I was on page 12 of 20 of that very Vanguard paper this morning when I decided to take a break and visit this site.

    Time to double up on the tinfoil hat!

  2. Canadian Couch Potato February 25, 2013 at 8:40 am

    Great minds think alike. :)

  3. February 25, 2013 at 10:01 am

    >>>>What are the long-term expected returns for stocks?

    6.35% if I’m not mistaken.

  4. Canadian Couch Potato February 25, 2013 at 10:05 am

    @LifeInsurance: What, only two decimal places? :)

  5. Canadian Dividend Blogger February 25, 2013 at 10:44 am

    Value is one of the best time-proven methods of determining future returns. This has been known for decades. 6.7% returns, conservatively estimated in a low inflation environment, is a lot better than savings accounts or the ol’ mattress.

  6. J A H February 25, 2013 at 1:37 pm

    It’s interesting to read the presentation here with the inclusion of 1% slippage included in the projected figures.

    Are many advisors usually of the habit to not take off that single per cent? I have a 45% bond, 55% equity portfolio that was initially conceived to be able to make 5.5%. This looks about 80 basis points higher than what one might conclude from the above, which doesn’t seem unreasonable. Slippage was never discussed in my planning.

  7. Justin Bender February 25, 2013 at 3:24 pm

    @JAH – I think a 5.5% rate of return assumption for your asset allocation seems perfectly reasonable (before fees, of course).

    Your planner’s assumptions and my own have one thing in common – in 10 years when we look back, I’m positive we’ll both be wrong ;)

    The main point is to make sure your assumptions are reasonable (i.e. based on current market valuations), and that you are not taking more risk than you need to take in order to meet your goals. For example, if you found that all of your goals could be met with a 4% return, would you consider reducing your allocation to equities?

  8. Andrew F February 25, 2013 at 6:37 pm

    CAPE yields are in real terms. You need to add inflation back in to get nominal returns.

  9. Canadian Couch Potato February 25, 2013 at 6:46 pm

    @Andrew F: Which is why I wrote: “Assuming an equity portfolio that’s one-third Canadian, one-third US, and one-third international/emerging, they now project a real return of 4.7%. If you assume 2% inflation going forward, that’s a nominal return of 6.7%.”

  10. Jon Evan February 25, 2013 at 7:26 pm

    The most difficult part for the average DIY investor is deciding on an appropriate asset allocation and what “course corrections” need to be made (if any) as the decades go by! The common fixed income/equity mix returns are based on backtesting which gives little comfort going forward and so future long term equity returns are the achilles heel of this traditional 60/40 asset mix as I see it. I friend of mine just quit as a DIY because of this uncertainty. Do you not think that this is where the Permanent Portfolio excels because there is at least the premise that its asset allocation is based more on forward planning in that it covers the range of market cycles that can develop and so there is at least the assurance that at least one asset group will perform?

  11. Canadian Couch Potato February 25, 2013 at 7:38 pm

    @Jon: I’m not sure why you believe that future returns for the Permanent Portfolio are any more predictable than those of a traditional portfolio. Half the PP is stocks and bonds, so for that portion the problem is exactly the same. Another 25% is gold, which is perhaps the most difficult asset class to estimate future returns (the idea that gold is a hedge against inflation, as I’ve written about before, is dubious).

    What I’ve described in this post has nothing to do with backtesting. The expected returns for bonds are based on current yields, not historical performance (which is much higher). And the Shiller CAPE metric is also an attempt to base expected returns on current valuations (however imperfect it may be). A model based only on historical returns would call for a balanced portfolio to return 8% or more.

  12. Andrew F February 25, 2013 at 8:09 pm

    It should be noted that there are big error bars on these estimates. 10 year returns could be +/- 3% per year.

  13. Jon Evan February 25, 2013 at 9:56 pm

    @CCP Regarding the PP, I said nothing of return predictability which is more a cognitive thing appealing to the rational investor to which MPT ascribes. But we know that investors are not rational as per behavioural finance. Instead, I spoke in terms of ‘comfort’ and ‘assurance’ that the PP provides going forward because it is based on tangible variables which are more easily understandable such as market cycles unlike the more abstract risk analysis upon which TP is built. The PP assures an investor that the market will at least be in one cycle with an asset which will outperform during that cycle. The TP has only two assets and then often in a disproportionate mix and so will under perform during deflationary and recessionary cycles. You disagree that gold is an inflationary hedge, but that’s because you can’t conceive hyperinflation occuring in North America. I hope you’re right, but it’s too bad you missed the gold returns of the last 6+ years!

  14. Canadian Couch Potato February 26, 2013 at 10:15 am

    Lot’s of criticism here, but few constructive alternatives, so I’m going to turn the discussion around:

    @Andrew: Assume you are a financial planner who is trying to help a client determine an appropriate asset allocation. The client is 10 years from retirement, and based on their current savings rate, they can reach their financial goals with a 5% rate of return. He has indicated he is not prepared to tolerate a portfolio loss of more than 10%. What asset mix would you recommend?

    @Jon: What portion of your life savings is currently in gold? If it’s not approximately 25%, why not?

  15. Andrew F February 26, 2013 at 11:06 am

    CCP, I wasn’t criticizing. I was just calling out something that wasn’t explicitly stated in your post. I think CAPE is the best way to intelligently talk about expected future equity returns. Definitely better than the “wishful thinking” approach.

    When we talk about expected portfolio returns of 4.9% for a 60/40 portfolio, it’s probably helpful to point out that that’s the mean of a confidence interval from, say, 2% – 8%. That might also help to shape investor expectations so there is less anger and recrimination if the realized return is in the bottom tail. I appreciate that if you’re dealing with people who may not have an appreciation for statistics, which can make talking about confidence intervals hard.

  16. Jon Evan February 26, 2013 at 11:25 am

    @CCP I’m sorry if I sounded critical. Your last paragraph of your current post made me realize why the TP is hard on investors. Too much work and anxiety to do these “course corrections”!
    This is why I favor the PP. Something about ‘permanent’ that gives confidence as well as the fact that it’s entirely passive, broadly diversified, low cost, no tactical allocations req’d., no course corrections but just annual rebalancing and the fact that the PP is based on forward planning (no return predictions req’d) just taking advantage of coming market cycles. This is contrary to the TP which is so nebulous with its constant risk analysis to determine asset allocations which in my opinion doesn’t work because humans are not mathematical computers and so behave differently and become irrational and volatile in time.

    No, not 25% gold because there has been evolution over time to the PP. Other inflationary hedges that I favor include silver, real estate, and commodities such as oil, agricultural, and forestry assets which make up my 25%.

  17. Canadian Couch Potato February 26, 2013 at 11:25 am

    @Andrew and Jon: I welcome criticism and debate, but I do think it’s important to suggest practical alternatives.

    Andrew, it’s not so much that it’s hard to talk about confidence intervals: I think all good financial planners are at pains to explain to clients that expected returns are almost certain to be wrong, and investors understand that. However, you need to pick a specific expected return if you are going to actually implement a portfolio. But you’re right that it might be helpful to say “we will use 5% as our expected return, but it’s reasonable to assume the actual returns could be anywhere from 2% to 8%.”

    I’m beginning to appreciate just how much investors detest uncertainty. Unfortunately, certainty just doesn’t exist in investing and financial planning, so at some point you need to accept that an imperfect, conservative model is the best we can do.

    Jon, if you’re not comfortable with a traditional portfolio and take comfort in gold, silver, commodities and forestry assets, that’s perfectly fine. I would never encourage anyone to use an investing strategy that made them uncomfortable. I just don’t buy the argument that expectations for stocks and bonds are based “predictions” and “nebulous” ideas, while expectations for hard assets are somehow “permanent” and reliable.

  18. Paul G February 26, 2013 at 12:04 pm

    Andrew: I’d add that making sure that clients are aware of the large potential errors also diminishes recriminations if returns are higher, but that clients took other decisions based on the expected returns in the meantime…

    IE: “Look at how well my portfolio did, if you’d been able to tell me I’d get 8%, I’d have gone to my nieces wedding in Hawaii last year” !

  19. Paul G February 26, 2013 at 12:07 pm

    That being said, I think having a reasonable basis for planning is essential, even though it’s pretty much garanteed that the result won’t be 100% right. It’s good to have a reasonable number to work with any projections we make have a very good odds of being “in the ballpark”.

  20. Brad G February 26, 2013 at 2:40 pm

    @CCP, from a comment of yours above:
    “The expected returns for bonds are based on current yields, not historical performance (which is much higher).”

    Perhaps I missed it but what is the rationale for using current rather than historical yields? On the equity side you’ve employed an heuristic that is based on historic data (CAPE) but then have mixed that with current yields. Is that an intentionally conservative decision?

  21. Canadian Couch Potato February 26, 2013 at 2:52 pm

    @Brad G: Sorry if this wasn’t clear. Over the very long term, nominal bond yields have been about 5% to 6%, but it is wishful thinking to use those figures for the foreseeable future, since the current yield on a broad-market bond fund is less than half that. If interest rates rise significantly in the future, then you can revise your expectation: this is one the “course corrections” I refer to on the post.

    You have to treat equities differently from fixed income in this context. If you buy a 10-year bond today, you know what its nominal return will be over 10 years. But if you buy a portfolio of stocks, you have no such certainty. So you need to make a reasonable estimate, but the questions remains, what criteria do you use for that estimate? The Vanguard paper suggests some criteria are useless while others, such as Shiller CAPE, are potentially helpful, if far from perfect.

  22. Brad G February 26, 2013 at 5:36 pm

    @CCP: Yes I agree using historical yields at this point would seem to be wishful thinking. But then what is the best estimate we can make? I suspect that backtesting the idea of using current market rates, especially at historic lows, does a poor job of explaining future returns of bond portfolios.

    Or maybe it does work. Have you seen any research on this topic?

  23. Andrew F February 26, 2013 at 5:44 pm

    Brad, the evidence I have seen indicates that 10 year bond yields are very good predictors of 10 year returns.

  24. Brad G February 26, 2013 at 6:05 pm

    @Andrew F: The context here is holding a portfolio that includes bonds, with different maturities, durations, etc. Perhaps held in ladders, funds, etc.

  25. BC_Doc February 26, 2013 at 6:39 pm

    @Andrew F: Regarding 10 year bond yields as predictors 0f 10 year returns– I’m not sure how useful they are now as an indicator with the US Federal Reserve buying up T-bonds in order to artificially depress long-term interest rates.

  26. Dan Hallett February 26, 2013 at 10:03 pm

    See this blog post for some illustrations on bond returns and rising rate scenarios.

    Also, on the broader topic of forecasting long-term returns, see this older piece from last year.

  27. Don D February 26, 2013 at 10:25 pm

    CCP, good work, and I appreciate all the comments. The projected yields assume a buy and hold with periodic re-balancing. It would be nice to see whether using shorts etc would materially affect these assumptions, + or -. Also, I wonder if any work has been published regarding the historical performance of advisors relative to their initial advice to investors.

  28. Dan Hallett February 27, 2013 at 11:28 am

    Dan, this is great work. No matter what anybody does, it’s all a guess. But the point is if somebody needs to hit certain performance targets to achieve their goals, you need to have some kind of framework that will assist you in at least trying to figure out what a portfolio will do going forward. And today, without exception, all of our return projections are lower than the historical record. It’s not enough to say, “your future returns are likely to be lower” because the client will want/need to know, “how much lower”.

    And while we use a slightly different approach, the basics are the same – i.e. driven by asset class fundamentals/pricing. It’s as objective an approach as I can think of. It need not be precise; but only approximately right.

  29. Harvey February 27, 2013 at 12:26 pm

    This is a very useful analysis and a wakeup call for me! Thanks Dan for your hard work :).
    For me, it is evident from this work that the traditional 60/40 port. with reducing equity as one ages may not be valid any more unless interest rates go back up but will they! Unless one accumulates a very sizeable portfolio most of us will have to carry a larger equity component than we thought into retirement. Retirement costs are difficult to predict. Not only is life span longer but unfortunately as well in the later years there may be other unanticipated expensive costs such as personal care and dental bills. A 3% annual return may not do it :(. Am I reading this correctly?

  30. Canadian Couch Potato February 27, 2013 at 12:37 pm

    @Harvey: Thanks for the comment. There are a lot of factors to consider, but I think it is fair to say that making a portfolio last through retirement will be harder than in the past. People are being encouraged to plan for a 30-year retirement, and it’s challenging to sustain a portfolio if it is mostly fixed income earning less than 3%. Unfortunately, the solution is likely “save more or spend less” rather than “take more risk.” I discuss that idea here:

  31. Eric February 27, 2013 at 2:39 pm

    According to a 2000 study by the Society of Actuaries, for every US couple aged 65, at least one of them will live to be 92. If you’re 50 today you may make it to 90; 4 more decades ! Why put 50 % in bonds ( the tradional asset allocation) ? you ”take more risk” by doing so. Interest from cash and low-yielding bonds alone is unlikely to pay for retirement, especially when you take into account inflation.

  32. Veronica February 27, 2013 at 7:16 pm

    @Eric, very interesting point. Indeed investors sometimes only consider the risks associated with portfolio diversification. Life expectancy is yet another variable which can hugely impact ones retirement living. As a female, I’m cognizant of the fact I will likely outlive my spouse.

    Thanks for this post, CPP! I’ve just commenced my first forray in DIY investing (utilizing a mainly divedend approach) at the age of 28. Wish me luck!

  33. Canadian Couch Potato February 27, 2013 at 10:03 pm

    @Veronica: Thanks for the comment, and good luck with your investing.

  34. NRD February 27, 2013 at 11:30 pm

    About long range planning assumptions for fixed income… I’m a stats geek so I get error bars, bell curves and the inherent uncertainty of this difficult but necessary planning process. Also, I’m as happy as a pig in muck with the couch potato strategy around equities and gratefully take the value from this post for equity return planning.

    However, I look at the assumption that says the expected value of the return (plus or minus a significant number) for something like XBB is a small fraction of a percent above inflation and my face at first just ghostly, turns a whiter shade of pale.

    I have many tens of thousands of dollars sitting in money market, losing ground to inflation and I know I have to do something with it – bonds or GICs. But it’s really hard to not just run to put it all in equities, perhaps a dividend ETF and stay right out of fixed income for a decade. What chance does XBB have at delivering a CAGR even a percent or so above inflation over the next 10 years in this environment? Are we not in for many years of negative returns down the road for XBB if we have the 10 year bond rate sit tight for a few years and then jitter its way from 2% to 5% or 6% 10 years from now?

    So this is to Dan or Justin or some of your fantastic reader/participants, Oldie, Noel, etc. – please hold my hand through this one. What are the most compelling reasons in this environment of rock bottom bond returns that I should stick some version of the tried and true advice about asset mix including bonds?

    p.s. I have read the July 4, 2011 post and maybe I read it wrong but it didn’t give me a great deal of comfort.

  35. Canadian Couch Potato February 28, 2013 at 12:18 am

    @NRD: There’s no getting around the fact that bond yields are barely above inflation today. But fixed income still has a role in most portfolios.

    You say “it’s hard not to just put it all in equities,” but that’s easy to say after watching the equity markets return over 100% during the last four years. How would you have felt had you lost half your savings between September 2008 and March 2009? Most people simply do not have the temperament to stay the course with an all-equity portfolio. The fact that you’re currently sitting on a large amount of cash suggests you probably fall into this category, too.

    You ask, “Are we not in for many years of negative returns” if rates rise over the next 10 years. Remember that while rising rates cause bonds to lose value, they also mean that new bonds will be issued with higher coupons, and these will offset some of the capital losses. If rates creep up gradually, a broad-based bond fund will not necessarily experience negative returns for multiple years. And remember, as long as you hold a bond fund for a period equal to its duration (currently about 7 years for XBB), you will not suffer a loss.

    I don’t mean to dismiss the the risks of bonds, but it’s important to remember that the alternatives also carry risks.

  36. Death and Taxes February 28, 2013 at 2:13 am

    CCP I am new to the site and appreciate all the articles here they are a great help.
    I am leaning towards the 60/40 ratio and am new to DIY investing. I am currently 43 and have just over 400k in my pension which of course I can do nothing about. My question is since I have that pension in place should I still follow the 60/40 rule or should I perhaps be more aggressive and pursue a 70/30 or even a 80/20 allocation?
    My second question is for someone who is using ETF’s should my fixed income portion be allocated to all bond funds or split them up with preferred shares?

  37. Dan Hallett February 28, 2013 at 7:58 am

    NRD, have a read of my blog post in response to all of the bond bears. Unless we get hyperinflation or you’re holding long-dated bonds, you’re not in for a long string of negative returns.

    The other issue pertains to the role of bonds in a portfolio. Personally, I continue to use bonds as generators of stable (albeit low) income and as portfolio stabilizers. I have also long used Benjamin Graham’s decades-old 75-25 rule – i.e. never hold more than 75% in stocks and never less than 25% – because of investing’s inherent uncertainty.

    Accordingly, holding a bare minimum of 1/4 in bonds is useful because when stocks inevitably fall hard, your bond component will accomplish two important things…

    1. They will limit your portfolio’s total loss from falling stock prices (i.e. you can recover more quickly from smaller losses)

    2. They will provide you with a segment of your portfolio that you can use to rebalance and buying stocks when they’re down will almost always help you recover from your losses more quickly – thereby boosting long term returns. You may also be interested in this most recent post on rebalancing.

  38. Canadian Couch Potato February 28, 2013 at 8:27 am

    @Death and Taxes: Your first question is a common one, but it’s quite complicated to answer. This Globe article does a pretty good job of outlining the main issues:

    Re: preferred shares, these may have a place in some taxable accounts (as a tax-advantaged replacement for corporate bonds), but they are not a substitute for a broad-market bond fund. They have a different set of risk factors: during a period of stock market declines, you want your fixed income to provide some balance, and you won’t necessarily get that from pref shares. In 2008, for example, they suffered big losses while government bonds performed well.

  39. Death and Taxes February 28, 2013 at 10:40 am

    Thank you Dan and CCP!
    My pension is through the union and other than one time (after 2008 it’s return was -.12%) and last year it was a dismal .7%. Other than that it has been getting between 5-12% returns. Due to pension contributions being subtracted from allowable RRSP contributions I have not had a lot to work with so TFSA’s for me are a sweet added perk!
    I believe I will go with 60/40 at least for the next year or two. If things in the market tank I at least will be able to capitalize on some undervalued funds.

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  41. Bet Crooks March 1, 2013 at 6:40 pm

    Thanks CCP and Dan for the calming words on bonds. With one of our work pensions, we have basically 3 choices: a bond fund, a TSX comp fund, and a global equity fund. Needless to say, we have had to use the bond fund for the fixed income part of the holdings. That was getting a bit scary as interest rates toy with rising. I have a little more confidence now that we should stay the course even when interest rates start to rise.

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