A Realistic Look at Future Investment Returns

If you've been involved in over the past few decades, you’ve probably gotten used to some pretty impressive returns. But it's wise to plan for a future where the good times don't roll quite as high. The fundamental rule is simple: over the long haul, stock market returns are driven by the real performance of businesses—their dividend yields and earnings growth.

However, a funny thing happened over the 43 years since September 1974. The market's returns actually outpaced what businesses themselves generated. Corporate fundamentals, meaning dividend yields (3.3%) and earnings growth (5.5%), added up to an 8.8% investment return. Yet, the stock market delivered an 11.7% total annual return. That extra 2.9% didn't come from thin air; it came from what we can call speculative return. This was a result of investors becoming willing to pay more for the same dollar of earnings, causing the price-to-earnings (P/E) multiple to more than triple, from a pessimistic 7.5 times to a lofty 23.7 times. This speculative boost accounted for a full quarter of the total returns investors enjoyed.

The Math Behind Lower Future Returns

Common sense alone suggests this kind of expansion can't happen again. A P/E ratio tripling was a historical anomaly, not a repeatable event. We’re likely facing an era of more subdued returns, a crucial concept for anyone today.

This isn't the first time we've faced this reality. Back in 2007, I made a similar case, projecting returns of about 7% for the decade ahead. The actual return for the S&P 500 from 2006 to 2016 was 6.9%—almost spot on.

So why the continued caution? Let's break down the sources of stock returns to see what the future might hold. This is a key lesson in : understanding where returns actually come from.

1. Today’s dividend yield is about 2%, not the historical average of 4.4%. For earnings, if we assume they grow alongside the U.S. economy at around 4% to 5% annually, our total investment return would be in the 6% to 7% range. Let’s be cautious and pencil in 6%.
2. With the P/E ratio starting at 23.7 times earnings, it's hard to see it expanding. A more likely scenario is that it contracts. If, over the next decade, the P/E ratio settles back down to a more modest 20 times, that change would subtract about 2 percentage points from the annual return.

Putting it all together, our simple forecast for the U.S. stock market comes out to around 4% per year (6% from investment return minus 2% from speculative return). Successful is about managing these expectations.

Do the Math Yourself

You don't have to take my word for it. If you think the P/E multiple will hold steady, then you can expect a 6% return. If you believe it will soar to 30 (I don't), you could see a 7.5% annual return. But if you think it might drop to 12, the total return would be negative. The point is to build your financial plan on rational expectations, not past performance.

It’s Simpler to Project Bond Returns

Forecasting bond returns is much more straightforward. While has three moving parts, bond returns are overwhelmingly driven by one thing: the interest rate when you buy them. The initial yield on a bond has historically explained about 95% of its return over the following decade.

Today, a portfolio split 50/50 between U.S. Treasury notes (yielding 2.2%) and long-term corporate bonds (yielding 3.9%) gives you a combined yield of about 3.1%. So, a reasonable expectation for annual bond returns over the next decade is 3.1%—well below the 8.0% average investors have seen since 1974.

The Real Killer in a Low-Return World: Costs

If we combine these projections, a balanced portfolio of 60% stocks and 40% bonds might generate a gross annual return of around 3.6%. But you don't get to keep all of that. This is where managing your portfolio becomes like —the effort you put into minimizing costs directly boosts your net profit.

Consider the math for an average actively managed fund, which can have costs of 1.5% or more:

• Gross Nominal Return:
• Investment Costs:
• Inflation:

That’s right—nearly zero. In a low-return environment, high fees can consume almost your entire profit. Now, compare that to a low-cost index fund with annual costs of just 0.1%:

• Gross Nominal Return:
• Investment Costs:
• Inflation:

It’s not a huge number, but it's infinitely better than zero. The relentless arithmetic of costs becomes magnified when overall returns are low. Diligent oversight of fees is no longer just a good idea; it's the core of a successful strategy. Treating your portfolio management as an can make all the difference.

How to Protect Your Returns

When , you have a few options to improve your outcome. Only two have high odds of success:

Strategies like chasing past performance or relying on professional advice to pick winning funds have historically proven to be poor bets. For most people, and experts alike, the path to success is paved with low costs and broad diversification. The future of will likely belong to those who understand this simple truth.