The investing world is shrinking. Not in the size of the dollars swashing around the markets — that’s still huge — but rather the magnitude of the returns that investors can expect. And this has serious implications for how you invest.
“This is a world of low numbers,” says Andrew Milligan, head of global strategy at Standard Life Investments in Edinburgh, Scotland. “It is a very important statement to get out there. Investors have to re-estimate what returns they are going to get.”
[See: 8 of the Most Incredible Investments of the 21st Century.]
Those returns aren’t going to be high. The idea of 10 percent or better annual returns for a portfolio that were once a possibility over a long period of time now look like distant history now in the post-financial crisis world. Worse still, it’s across the spectrum of investing alternatives. “These low numbers aren’t just for equities but for all asset classes,” Milligan says.
Why is this happening? These downsized returns are the result of policy decisions made by central banks around the world. The whole idea of easy monetary policy was to create low borrowing costs, create capital and force investors “into riskier assets,” says Stephen Guilfoyle, managing director of NYSE floor operations for Deep Value Execution Services.
The Federal Reserve believed investments in riskier assets would spur economic growth. What has happened is growth has remained subdued. With that has come low inflation and low interest rates.
For instance, the U.S. Bureau of Labor Statistic’s consumer price index, which is a commonly followed measure of inflation, has been hovering substantially lower than 2 percent a year. Prior to the financial crisis of 2008, the same metric showed greater inflation, about 2.5 to 4 percent a year.
U.S. economic growth for the first quarter of the year was anemic. The government’s first estimate was a paltry 0.5 percent, well below historical levels. Low inflation and low growth means low investment returns. Worse still, investors don’t seem to have caught on to that there are serious implications for their investments.
Fees add up. “Small numbers mean you really care about fees,” says Paul de Janosi, senior advisor at consulting firm SSA & Co. Even seemingly modest costs can dramatically reduce the net amount that eventually goes to the investor.
A good example is mutual fund fees. If the expected return on a corporate bond fund before fees is likely to be around 3 percent a year, then annual expenses of 1 percentage point would mean that the net return drops to 2 percent.
A way to reduce the impact of fees is to buy low-cost index funds, such as those offered by Vanguard. Sometimes the fees can be as low as 0.05 percent, or $5 per $10,000 invested per year, depending on the fund. That can preserve an investor’s nest egg.
The asset mix matters. It used to be that the rule of thumb for constructing a portfolio was to have around 60 percent invested in stocks, with the rest in bonds, cash, real estate and other asset classes. The amount of stocks would be higher for younger investors and lower for those with a shorter time horizon.
[Read: 4 Conservative Ways to Lock Away Wealth for the Future.]
“Now you need a bigger portion of stocks,” de Janosi says. “Instead of 60 percent, consider 70 percent.”
Stocks are typically more volatile than most other asset classes but over long periods of time they have consistently produced higher returns than bonds or cash. By allocating more to stocks, investors can hopefully grow their money faster than by stocking with the traditional 60-40 mix.
Smaller stocks help beat lower returns. In addition, investors might want to consider smaller companies rather than larger ones.
The Russell 2000 tracks small capitalization stocks, whereas the Standard & Poor’s 500 index focuses on the largest publically traded companies.
The advantage of small-cap stocks is that they tend to grow faster than large-cap stocks.
For instance, from July 1, 2000, through May 6, the iShares Russell 2000 (ticker: IWM) exchange-traded fund, which tracks the Russell 2000, grew 105.9 percent versus 35 percent for the SPDR S&P 500 (SPY). Both returns exclude dividends.
[Read: How to Invest in Foreign Stocks.]
The downside of such higher returns is that they are riskier. The prices of smaller stocks get knocked around much more than larger ones. But to some investors, that’s OK. “I personally take a view that I need to take more risk,” de Janosi says.
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The Incredible Shrinking World of Investments originally appeared on usnews.com
