Settling for Six

Jonathan Clements

SINCE RETURNING to life as an ink-stained wretch early last year, I have been talking about the likelihood of modest stock returns. My best guess: A global stock portfolio might notch 6% a year over the next decade, while inflation runs at 2%.

It turns out that the person I admire most on Wall Street, Vanguard Group founder John Bogle, also has modest expectations. This is no great surprise: How I think about stock returns has been greatly influenced by Jack’s writing.

Back in 1991, Jack presented a delightfully simple method for analyzing stock returns. He distinguished between the market’s investment return and its speculative return. The investment return consists of the market’s initial dividend yield, plus growth in earnings. What about the speculative return? That’s reflected in the varying price put on those earnings, as measured by the market’s price-earnings ratio, or P/E.

When investors are exuberant, the P/E ratio might climb above 20. When they’re fearful, it could fall below 12. But if there’s no change in the P/E, then all you collect is the investment return: You pocket the dividend yield, plus the price of your shares should march higher along with earnings.

So what does the future hold? In an article just published in the Journal of Portfolio Management, Jack and co-author Michael Nolan note that the U.S. market’s initial dividend yield is around 2% and that “earnings seem likely to increase at around 5%, or perhaps even less, during the coming decade.” That would put the market’s investment return at 7% a year. But they say a decline in the P/E ratio toward historical norms might knock one percentage point a year off the market’s return, “reducing stocks’ annual investment return of 7% to 6% per year in nominal terms.”

What should investors do? That’s easy. Americans need to save like crazy to compensate for the market’s likely modest gains—and they should make sure they capture as much of those gains as possible, by opting for low-cost market-tracking index funds.

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