Commentary on Risk and Return Assumptions

Commentary on Risk and Return Assumptions

It is an uncertain task when estimating future risk and return levels of stocks and bonds. Yet in proper retirement planning and investment planning we must do just that. As a firm philosophy, we do our very best to have a goldilocks scenario where the projections aren’t too conservative or too aggressive but are ‘just right.’ For if projections are significantly conservative, clients may have to work longer or spend less than they otherwise would. Conversely, if projections are too aggressive, clients may be at risk of running out of money. Neither of these are desirable.

Through continuing analysis and discussions, we felt it to be appropriate to change our risk and return assumptions used in client plans. These changes will mean an increased level of projected risk and a relatively significant reduction in expected returns after inflation. Therefore, all clients should expect decreases in the success results of their financial plans unless other compensating factors exist.

For returns, based on our belief that there has been a fundamental change in the capital markets; (e.g., no more investment banks), we considered that at least for the foreseeable future, investors cannot count on leverage (i.e., expanding P/E multiples) to ratchet up return on the equity markets. As a consequence and  as noted in a 2009 revision, we reached the conclusion that in spite of the significant loss of market value from 2007-2009, forward looking returns are likely to remain modest as compared to long term historical returns. Therefore, we have revised forward looking return assumptions, reducing the expected real return on the broad equity market from 6% to 5.5% and fixed income expected real return from 2.5% to 1.75%.

For risk as measured by market volatility, volatility is likely to remain relatively high. Diversification is more difficult to come by today, because correlations have also increased across all styles (growth/value) and classes (large/mid/small). Unfortunately, that reality seems to be permanent. As a result our projections reflect a modest increase in risk (standard deviation) and continuation of the high correlation assumptions.

While these broad-based assumptions are being reflected in our retirement planning projections for you, we have taken particular actions in our portfolio construction process to best address these less-than-rosey market expectations. Adding a portfolio protection element  to mitigate volatility and to provide increased diversification is just one example.

Having proper expectations is critical to being a successful investor. This is why we are communicating these key changes to you. Return expectations need to be tempered and lowered from historical norms. Heightened relative volatility will likely persist for some time to come if not indefinitely.

We will continue to do our very best to be trustworthy guides as we help our clients shape and realize their life dreams and goals.

Kevin Kroskey, CFP, MBA