4% Is All You Get! Why Stock Investors Could Be in for Disappointment

Farmer in despair over the Depression in 1932. Source: U.S. National Archives and Records Administration.

In the wake of well-received earnings from several megacap technology companies, U.S. stocks look like they will close out the week on a positive note. The Dow Jones Industrial Average and the S&P 500 are up 0.57% and 0.78%, respectively, at 1 p.m. EDT.

From daily returns to next-decade returns (which are easier to forecast), what annualized return, inclusive of dividends, do you expect to earn on the equity portion of your investment portfolio over the next 10 years? For context, the long-term historical total return on U.S. stocks is roughly 9.5% per annum.

Jack Bogle, a towering figure in the investment business, who is no perma-bear, thinks stock returns could be less than half that figure.

The Bogleheads Conference took place in Philadelphia in the middle of this month. The conference is named in honor of Jack Bogle, the founder of index investing powerhouse Vanguard Group. Bogle was in attendance; research companyMorningstar asked him for his expectations for asset class returns over the next decade.

In answering, Bogle carefully explained his methodology (which is sometimes referred to as "Bogle's method") and his assumptions (my emphasis):

In other words, reasoning solely on the basis of earnings and dividends, 8% is an aggressive baseline forecast (we'll see why I label it aggressive below).

Fine, but what is this "speculative return," and how does it alter the 8% forecast? Here's Bogle (my emphasis):

Add the investment return to the speculative return, and you're left with an expected return for stocks of 8% + (-2%) = 6%. In fact, Bogle thinks that's the best we should expect, but his baseline expectation is lower:

Not a very good number, indeed! Keep in mind that this is before the punitive effect of inflation. Assuming a 2% inflation rate, you're left with a 2% real return.

Four percent annually is Bogle's expected return. Now, stock returns are volatile, so it's certainly possible actual returns will turn out to be higher, perhaps significantly so (it could also be lower, naturally). Returns volatility can swamp the expected return, even over a 10-year period.

Still, the question is what assumptions you wish to make in planning your financial future. In that regard, an expected return is not a bad place to start. If you take Bogle's forecast seriously, two conclusions are possible.

First, many investors ought to adjust their expectations downwards, with all that that implies.

Second, investors who want to earn a return in excess of roughly 5% ought to be allocating money to active managers over index funds, or perhaps to foreign stocks (although Bogle would probably counsel against both of these).

The article 4% Is All You Get! Why Stock Investors Could Be in for Disappointment originally appeared on Fool.com.

Alex Dumortier, CFA, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.