Is It Realistic to Base Personal Financial Planning on 8% Return Scenarios?

The discussion surrounding the realistic expected returns for personal financial planning is an important one, especially in light of varying historical averages and market conditions. This essay will explore the misconceptions surrounding the use of an 8% return as a baseline, delve into the nuances of portfolio allocation and manager performance, and emphasize the importance of incorporating risk management strategies into your financial planning.

Common Misconceptions and Realistic Expectations

The assumption that a 100% US equity portfolio offers a reliable 8% return is often misleading. An examination of longer-term historical averages may lead one to believe that a 6-7% return is a more realistic expectation, rather than the 8% return sometimes cited. This is particularly true when considering the complexities of market conditions and the impact of inflation.

Valuation multiples, such as the P/E ratio, play a significant role in determining future returns. In today's markets, given the current valuations, a conservative estimate of a 6.5% return on US stock assets is more appropriate. However, this must be balanced against the pathetically low yields available on bonds, which can significantly reduce the overall return. The arithmetic and geometric return expectations must be carefully considered, and the net result often falls short of an 8% return.

Portfolio Allocation and Manager Performance

One of the key considerations in personal financial planning is the allocation of assets. For a more balanced portfolio, one should assume a mix of US stocks, foreign/EM equities, municipal bonds, foreign bonds, private equity, and hedge funds. Each of these asset classes has different return expectations:

US public equities: Dividend yield of 2%, a 100-year average of 1% in real earnings growth, and an inflation expectation of 2.5%. This results in a nominal return expectation of 5.5%. Factoring in the potential impact of rising or falling P/E ratios, a 6.5% expected return can be derived. Bonds offer low yields, reducing the overall potential for high returns. Private equity and hedge funds have their unique risk and return profiles, which can either enhance or detract from overall portfolio performance.

While this is a simplistic overview, it is clear that attempting to achieve an 8% return from a diversified portfolio is challenging and unrealistic. Additionally, the performance of money managers can significantly impact the actual returns achieved. High fees and often mediocre performance by money managers can result in a significant detraction from the expected return.

According to various studies, the majority of individuals tend to buy high and sell low, leading to suboptimal returns. Even with a well-thought-out asset allocation and a carefully selected set of managers, if investors panic and sell during market panics, the entire plan is likely to be derailed. However, adopting a disciplined approach, where investors sell high and buy low, can lead to significantly better outcomes.

Conclusion

Base your personal financial planning on a more realistic set of expectations, such as a low-to-moderate return range of 3% to 5.5%, factoring in the impact of inflation. This will provide you with a solid foundation for achieving a sustainable retirement income that is resilient to market fluctuations. Remember, the key is to have a diversified portfolio, carefully selected managers, and a disciplined investment strategy to navigate the unpredictable nature of the financial markets.

Keywords: financial planning, investment returns, retirement planning