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The Portfolio Solutions 30-Year Market Forecast for 2012

Portfolio Solutions is a low cost investment advisor registered in all 50 states. Our fee is 0.25%* per year subject to a fixed minimum. All client portfolios employ a global balanced approach using Modern Portfolio Theory. We believe proper asset allocation and low fees combined with prudently selected index funds and exchange-traded funds (ETFs) lead to greater wealth with less risk.

Investors Expect to Be Paid for Risk

Each year, Portfolio Solutions® puts forth a long-term forecast for stock and bond market returns. We know it’s not possible to predict short-term return, but it is possible and necessary to estimate long-term expected returns. These estimates form the basis for investment decisions.

Our asset class forecast relies on the simple belief that market participants, as a group, will invest in risky asset classes when the return expectation is high enough. Current risk levels in the markets can be used to judge what those expected returns are. Higher risk levels mean investors are demanding higher returns and vice versa.

This year, the return forecast relies on five primary drivers: market risk as measured by comparative price volatility with other asset classes; the Federal Reserve’s long-term target for US GDP growth; market implied inflation based on the difference in yield between long-term Treasury Bonds and long-term Treasury inflation protected securities (TIPS); current cash payouts from bond interest and stock dividends; and fiscal and monetary policy.

One problem with free markets is that they are never truly free. Artificial forces are always at play from government fiscal policy (tax and spend) and central bank monetary policy (inflation and full employment).

When governments tax, borrow and spend on targeted programs, there is less money available for private spending and borrowing. This leads to higher interest rates, which lowers the incentive for businesses to grow.

Federal Reserve monetary policy acts as an economic traffic cop. The Fed attempts to keep the economy moving forward at a controlled pace by manipulating interest rates. They don’t want to move too quickly because that can cause high inflation, or move too slowly because that slows the economy and increases unemployment.

In the past few years, we have taken into consideration the unprecedented size of the Federal Reserve’s balance sheet holdings, which include primarily Treasury bonds and mortgage-backed securities. These monetary stimulus policies have pushed intermediate- to long-term interest rates lower than they would be otherwise.

Experienced investors know there’s no free lunch. The excess total return paid to bond investors must be paid back in future years in the form of lower expected returns. Read Fears of Soaring Rates are Overblown for a detailed explanation and estimates of these lower returns.

Based on prices, the expected risk is low in Treasury securities and investment-grade bonds. Accordingly, the expected credit premium over inflation from these securities is also low. It doesn’t matter if these low prices are created by Fed actions or market pricing, low prices mean low expected long-term returns. Our 30 year forecast for investment grade bonds has been lowered by 0.2 percent since last year.

In contrast, equity markets are experiencing higher risk characteristics than normal. Thus, a higher than normal risk premium should also be expected.  Our 30-year forecast for equity has been increased by an average of 0.2 percent since last year.

Inflation expectations have also been lowered. This was due primarily to the narrowing spread between long-term 30 year Treasury Bonds and 30-year TIPS. The average spread has decreased from 2.8 percent during 2010 down to 2.5 percent in 2011.

Results and Limitations

The table below is our expected return for all major equity and fixed income asset classes over the next thirty-years. The table is provided to be a guide when constructing a long-term diversified portfolio. These estimates are not expected to be completely accurate. Actual returns will likely differ in several asset classes.

Of all the returns we estimate, perhaps inflation is the most difficult to forecast. There are so many variables that affect inflation that it’s nearly impossible to guess the future. This is why we prefer to show expected market returns on a pre-inflation basis. We have more faith in our inflation-adjusted (real return) forecasts than our post inflation forecasts.

Thirty-Year Estimates of Bonds, Stocks and REITs Assuming a 2.5% Inflation Rate

Asset Classes

Real Return

With 2.5% Inflation

Relative
Risk*

Government-Backed Fixed Income
U.S. Treasury bills (1-month maturity)

0.3

2.8

2

10-year U.S. Treasury notes

1.3

3.8

6

20-year U.S. Treasury bonds

1.8

4.3

8

20-year inflation protected Treasury (TIPS)

 1.9

 4.4

8

GNMA mortgages

1.8

4.3

8

10-year tax-free municipal (A rated)

1.5

4.0

7

Corporate and Emerging Market Fixed Income
10-year investment-grade corporate (AAA-BBB)

2.3

4.8

9

20-year investment-grade corporate (AAA-BBB)

2.5

5.0

10

10-year high-yield corporate (BB-B)

4.0

6.5

15

Foreign government bonds (unhedged)

2.0

4.5

8

U.S. Common Equity and REITs
U.S. large-cap stocks

5.5

8.0

19

U.S. small-cap stocks

6.5

9.0

22

U.S. small-value stocks

7.5

10.0

26

REITs (real estate investment trusts)

5.5

8.0

19

International Equity (unhedged)
Developed countries

5.5

8.0

19

Developed countries small company

6.5

9.0

22

Developed countries small value companies

7.5

10.0

26

All emerging markets including frontier countries

8.5

11.0

29

*The estimate of risk is the estimated standard deviation of annual returns.

Laddering Risk Premiums

Another way to look at asset class expected returns is by layering risk premiums. As you go down the list in the table below, each asset class has the premium of the asset class or category above it, plus a new risk premium. Adding risk premium layers derives an asset class expected return.

 

T-Bills

10-year Treas. Notes

10-year Corp. Bonds

Large-Cap Stocks

Small Value Stocks

Real risk-free rate

0.3%

0.3%

0.3%

0.3%

0.3%

Term risk premium(intermediate)

1.0%

1.0%

1.0%

1.0%

Credit risk premium (intermediate)

1.0%

1.0%

1.0%

Equity risk premium

3.2%

3.2%

Value stock risk premium

1.0%

Small stock risk premium

1.0%

Real Expected Return

0.3%

1.3%

2.3%

5.5%

7.5%

Inflation

2.5%

2.5%

2.5%

2.5%

2.5%

Total Expected Return

2.8%

3.8%

4.8%

8.0%

10.0%

No one knows exactly what the returns of the markets will be over the next thirty years. However, the risk in an asset class is fairly stable over time, and that tends to drive the long-term risk premium.

The acceptance of a market forecast is an important step to creating a proper asset allocation. The forecast should always try to err on the conservative side. It is wise to expect and plan for lower returns and then be pleasantly surprised if the forecast is too low than to rely on a rosy forecast and possibly run out of money later in life. As the saying goes, it is better to be safe than sorry.

© 2012 Portfolio Solutions, LLC

*A total relationship value below $1 million is subject to a $625 minimum quarterly fee in lieu of the 0.25% annual management fee.

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