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The Market Is Up! Your Expected Future Returns Just Went Down!

I encourage all of my clients and readers to not spend too much time watching their portfolios move up and down, or the daily gyrations of the market. For good reason: one could get quite queasy if they do! That said, it is probably a good bet that those who have investment portfolios have taken notice of the positive direction taken by the equity markets this year. More recently, things have really accelerated as the market as a whole is now more than 17% higher for the year as measured by Vanguard’s Total Stock Market Index Fund.

It is quite natural to feel better about things when the market is going up and one’s portfolio is reaching new highs. I admit I feel better as well. But, the rational financial planner in me knows better. When the market achieves better than average returns in a given year, our future expected returns go down. Let me explain.

Let’s imagine we go back to January 1st of this year and you are thinking about a realistic future return for your portfolio. Most financial professionals would have looked at the low interest rate environment and felt that the best one should expect from fixed income is a 2-3% return over the next 10 years. (This assumes you are investing in very safe investment-grade bonds.) For the equity markets one could certainly argue about whether the market is over or under-valued at any given time. Depending on the exact mix of various asset classes I think it would be reasonable to expect 8-10% over the next 10 years. So, a moderate asset allocation of 60% to equities and 40% to fixed income might average out to an expected return of say 6-6.5%. For purposes of this discussion, let’s say your set your expected 10-year investment return to 6%.

In the first year of this 10-year period you experience a return in your portfolio of 10%. This is significantly better than your original expected return of 6%. At the end of this first year you only have 9 years left in the original 10-year period. If you outperformed in the first year, does that not mean that they next 9 yearsmust average less than 6%? It sure does. Hence, my caution to everyone reading this: adjust your expectations lower as the market continues to climb. Even better, make sure you rebalance your portfolio from time to time to keep the risk of your portfolio in line with your original expectations.

To be clear, I am in no way making a prediction about the future. Rather, I am communicating the relationship between actual returns and expected future returns. On the flip side, when the market goes down, your expected future returns will go up. It is important to realize that expected returns are not guaranteed returns.

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