Midyear Investment Review and Outlook : Realistic Expectations Could Save You Money

Delores G. had a sizable fortune after her husband died in the early 1980s. But within 10 years, more than half her $500,000 cash estate had been lost in a series of speculative investments and financial cons.

Rather than blame the con men and promoters, Delores blames her losses on unreasonable expectations. She says she was a walking mark because she didn’t know that “safe” investments don’t promise double-digit returns in times of modest inflation.

Delores fell into a common trap. There are millions of people like her who simply don’t understand how to gauge realistic investment expectations, experts say. But gauging what’s reasonable is easy. And it can save investors from costly mistakes and protect them from financial cons.

Now, as many investors take a midyear look at their investments, they would be wise to consider whether their investment expectations are realistic in today’s market.

Normally, you can gauge expectations by looking at rates paid on Treasury securities, says Mark W. Riepe, vice president of Ibbotson Associates, a Chicago-based investment consulting and data products firm. If your time frame is two years, consider what two-year Treasuries pay. Every percentage point above the Treasury yield is a step up in risk, he notes.

In other words, if someone is promising a 20% return at a time when Treasuries are yielding 5%, you’re taking a huge risk. However, if Treasuries are yielding 15%, a promise of a 20% return might not be inherently dangerous.

However, investors in stock and bond markets should realize that return expectations are long-term by nature. Those who expect to need their money in less than two years should either keep their investments in cash equivalents--such as certificates of deposit and Treasury securities--or recognize that they’re speculating, says Neal Litvack, executive vice president of Fidelity Investments in Boston.

Why? Over short periods, the only thing you can reasonably expect of stock or bond returns is that they’ll fluctuate. Often they’ll fluctuate wildly.

Between 1981 and 1990, for example, the variation between the best and worst years in these markets was 37% for stocks and 44% for bonds, according to T. Rowe Price, a mutual fund company headquartered in Baltimore.

In other words, if your time horizon is short, you should expect to earn modest returns--a few percentage points over the rate of inflation--in safe investments. Or, you can speculate, in which case you could make or lose a fortune.

Notably, many investors have forgotten that it is risky to invest in these markets with a short-term horizon because the markets were unusually calm for more than a decade, says Richard Bernstein, manager of quantitative analysis at Merrill Lynch in New York. However, now the markets are “reverting to a more normal risk-reward relationship.”

Translation: “If you want unusually high returns, you’re going to have to give up sleeping at night,” Bernstein says.

If you’re investing in bonds, you need to have at least a two-year time horizon, says Litvack. If you’re investing in stocks, you should be committed to stick with it for at least five years, he says. Those with a long time frame can take a look at that investment category’s history to determine what a reasonable rate of return should be.

Since 1926, big-company stocks have earned an average compounded rate of return equal to 10.33%, according to Ibbotson. Over the same period, small company stocks gained 12.36%. Long-term government bonds earned 5.02%, Treasury bills averaged a 3.69% return, and inflation averaged 3.13%.

Because this period included such economically earth-shattering events as the Great Depression, World War II, the peak period for U.S. inflation and the “oil crisis,” not to mention the Korean, Vietnam and Persian Gulf wars and periods of recession and expansion, it’s safe to assume that these returns are reasonable through thick and thin. If there’s a global nuclear war, of course, all bets are off. Otherwise, long-term investors can reasonably expect about a 10% return in stocks and at least a 5% return on government bonds.

Or, to put it another way, you can expect to earn 7% to 8% over the rate of inflation when investing in stocks, and you can expect to earn 2% to 3% over the inflation rate when investing in U.S. government bonds, Riepe says.

The statistics on international investing don’t go back quite as far. However, Ibbotson has tracked global returns since the mid-1970s. Between 1975 and 1993, a diversified portfolio of international stocks returned 15.75%. A diversified portfolio of international bonds returned 12.48%.

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It’s worth noting, however, that U.S. inflation--and U.S. investment returns--were higher over this fairly short period than they were in the nearly 70 years noted above. Since 1975, U.S. inflation averaged 5.53%, large-company stock returns averaged 14.21% and returns on U.S. government bonds averaged 10.48%.

As for other investment categories: Tax-favored municipal bonds earned an average of 3.71% pretax over a 44-year period, according to T. Rowe Price. However, because U.S. tax rates dropped in the mid-1980s, returns on municipal bonds rose. During the 15-year period ended Dec. 31, municipal bond yields averaged 8.39%.

(Muni bond yields naturally go in the opposite direction of tax rates because investors buy them on the basis of after-tax returns. A 5% municipal bond has an after-tax return of roughly 7.1% when you’re in the 30% tax bracket. However, when you’re in the 70% tax bracket, the same bond boasts a 16.6% after-tax return. That’s the amount you would have to earn on a taxable investment to have the same amount in your pocket from the tax-free investment.)

Real estate investment trusts, meanwhile, returned between 8.7% and 15.3% over the past 20 years, depending on the type of REIT.