To perhaps state the obvious, an essential element of managing risk when investing is to be mindful of the risk-reward ratio from each potential investment. At Miles Capital, we typically start by evaluating the risk of loss, but it is also important to ask what a reasonable upside might be. That is, what is my “expected return” from this investment or, indeed, my entire portfolio? 

Underestimating expected returns can cause one to stretch for returns by investing in riskier assets than may be appropriate. Overestimating returns – which to be sure is the more common error – has led many individuals and some of the nation’s largest pension plans to underinvest relative to their future needs (i.e., save too little).    

On a hot summer day, it’s good to find a place in the shade, pour a cool drink and contemplate the question of what investment returns might look like going forward – not in the next few weeks or months, but over many years.

One such perspective is provided by the very capable folks at GMO LLC in Boston. Each month, they update their 7-Year Asset Class Real Return Forecasts for 12 different asset classes. And their track record is very good. Right now, their projected annual return over the next seven years for U.S. large-cap stocks is a 1.7 percent loss, for U.S. bonds, it’s zero percent, and for cash, a 0.4 percent loss. Keep in mind that GMO is forecasting real returns, so these numbers exclude their inflation forecast of 2.2 percent. They do see a bit more promise in international large-cap stocks, projecting annual returns of 0.7 percent, and emerging market stocks, at 3.6 percent.

If GMO is right, and you are managing a pension plan or a foundation’s investment portfolio, or simply getting near retirement, contemplating near zero real returns over the next several years is a sobering thought. The typical foundation tries to invest to maintain or grow its real purchasing power while at the same time spending something in the neighborhood of 4 percent (or more) annually in support of its mission. That may be very difficult to do, at least with the asset classes modeled here, and it is worthwhile thinking through the implications in advance.

And then there is the very long term. In an article titled “The Paradox of Wealth” by William J. Bernstein published in the Financial Analysts Journal last year, Bernstein took a much longer view of expected returns from investing and also came to an interesting conclusion: that “in the very long run, an increase in societal wealth and well-being carries a paradoxical cost, namely, a reduction in the expected return on both risky and riskless assets.”

Examining history as far back as ancient Mesopotamia, Bernstein makes the case both theoretically and empirically that as wealthy societies get richer – and therefore have more capital to invest – “the supply-demand equation shifts in favor of capital’s consumers.”  He sees this particularly with respect to rapidly falling borrowing costs (down from 125 percent per annum in prehistoric periods), but also from evidence that average price-earnings ratios have risen about one point every 17 years over the past 132 years (making stocks more expensive).

With interest rates at historic lows, and GMO projecting stock returns well below their long-term average of 6.5 percent per annum, now is a good time to be thinking about whether long-held assumptions about returns from various asset classes are likely to continue going forward. It may well be that each of us will need to be setting a bit more aside in the days to come.