The 10% Problem - Forward Management - March 1, 2011 Page 1 of 4

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The 10% Problem

Forward Management
By Nathan Rowader
March 1, 2011

Many investors continue to expect 10% returns — but these days, are doing well if they earn 5%.
They need to understand why major shifts in the global investment climate are challenging them to
reset return expectations and reboot their plans.

After six decades of double-digit average U.S. stock market returns, many American investors may have
come to expect that they will earn similar returns going forward. And why wouldn’t they? From 1948 to
1978, for example, the U.S. stock market generated an average annualized total return of 10.7%. Over
the next three decades, the period spanning the longest bull market in history, the average was 11.2%. 1

The expectation of 10% annual returns also has roots in academic theory and investment industry
practice. Counseling investors to accept short-run losses as part of a winning long-run strategy, financial
professionals typically used historical return averages as the basis for their financial models and asset
allocation formulas.

Over time, these models and formulas were adjusted in response to changing conditions and periodic
bear markets — more international exposure here, less technology there, and so on. Still, the
conventional wisdom remained the same, based in part on the 10% calculation: “Diversify, buy and
hold, stay the course, and you’ll have a good chance of reaching your financial goals.”

Of course, using the rearview mirror as a guide works only so long as the terrain remains the same.
When the 2008 financial crisis shook the global economy, and somewhere between $5 trillion and $10
trillion in asset value disappeared in a matter of weeks, it showed how suddenly the tectonic plates of the
financial markets could shift.2

Much of the dust has now settled and markets appear to be in recovery mode. Yet the upheaval hasn’t
ended for those investors whose retirement plans are still predicated on 10% average annual returns, but
now find themselves earning perhaps half that amount. For them, the real question is…What now?

Are We Entering an Era of Lower Returns?

After the experiences of the last three years, investors may now be more aware of the potential downside
risks of investing. But they still may not fully understand why markets today are different than in the past
— or why 10% returns may not be the norm going forward. Some of the key reasons why things have
changed:

Average equity market gains over the past 30 years are likely unsustainable.
Look at long-term return averages alone, and it appears that the U.S. stock market performed as well or
better over the past three decades than it did in the immediate postwar era [Figure 2].
But factor in changing price/earnings (P/E) ratios, and a different story emerges.
• In the 30-year period following the end of World War II, market gains were fueled by the
nation’s healthy rate of economic growth. The U.S. economy allowed for strong growth in
dividends and earnings with no rise in P/E ratios.
• Over the next 30 years, average returns were somewhat better. But in part, these gains
reflected expanding P/E multiples. Rising P/E ratios showed that investors were willing to
pay more for equity growth potential, even with slower earnings growth.
• Meanwhile, in the early 1990s, interest rates dropped and, for the most part, stayed

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persistently low.3 Once the cost of borrowing money was below their rates of earning
revenue, companies began relying more and more on external sources of capital. In
hindsight, it now seems clear that many companies had balance sheets that were highly
leveraged relative to historical levels.4 The result was a “sideways” decade for equity
returns — the dismal 2000-2010 period that spawned a global recession and saw some of
the worst years of U.S. stock market performance since the Great Depression. 5

Global economic conditions may be fundamentally shifting.

Developed markets (the U.S., Western Europe, and Japan), which still account for about three-fourths of
the global economy,6 are grappling with economic problems that may drag down equity market
performance, including sluggish gross domestic product (GDP ) growth, interest costs of massive public
debt, aging populations, shrinking public-sector consumption, and slower private-sector spending. While
no one can predict the future, some experts believe that over the next ten years, investors may be facing
a climate of lower returns due to slower overall growth of the global economy.

Market volatility has been on the upswing.

Over the past ten years, equity market downturns have been deeper and more frequent than in prior
decades [Figure 3]. It is axiomatic that investors will find it harder to get ahead in the long run if they
keep losing money in short-run dips and downturns. Investors likely understand the impact of down
years on their investment progress, but may not recognize how much the market’s short-term slides can
undercut their returns.

Equity market correlations have been rising.

Historically-based assumptions of non-correlation were shattered during the financial crisis, when most
major asset classes declined in seeming lockstep. 7 Beyond that, correlations between equity markets in
the U.S., developed nations, and emerging markets generally have been rising over the past decade or so
— a likely result of globalization and the 24/7 news cycle.8 Higher correlations make diversification
more challenging and may leave investors even more vulnerable to drawdown risks.
Understanding these trends may help investors to recognize that, even in a relatively stable investment
climate, it can be misleading to peg future investment plans and return expectations solely on historical
averages. For one thing, actual returns can vary dramatically based on the timing of market entry and
exit points alone. But in an era when the forces of globalization, technology, and demographic change
appear to be fundamentally reshaping the world’s economic landscape, investors must take to heart the
stock phrase, “Past performance is no guarantee of future success.”
What Can Investors Do?
Rather than relying on traditional practice and historical guides, investors will need new solutions and
fresh thinking to navigate a shifting, uncertain investment climate. Current trends point to three ways
investors can adapt to new realities

1 Rethink risk management.

A “conservative” investment approach is traditionally defined as one in which portfolios are close to
fully-invested in a diverse mix of long-only stock and bond investments. Yet, this traditional approach
may actually heighten certain risks at a time when broad market downturns have been more frequent and

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mainstream markets are more correlated than in the past [Figure 4].

In today’s mercurial markets, investors may wish to consider an approach that:

• Is geared to achieving positive absolute returns, rather than relative return — in other
words, one that is more concerned with avoiding asset losses than outperforming market
benchmarks.
• Incorporates judicious use of hedging, short-selling, and leverage. While such techniques
have long had an aura of risk, skillful investors have shown how they can be used to cope
with volatility and, potentially, even capitalize on it. In essence, long-only investment
assumes that markets will eventually rise, which may not be the safest position when
markets are volatile.
• Allocates a significant share of assets to alternative asset classes — such as real estate
investment trusts, commodities, and emerging and frontier markets — with the potential to
deliver greater portfolio diversification and higher returns than the traditional mix of stock
and bond investments alone. Over the past decade, major institutional investors have
resoundingly embraced alternative asset classes, which now account for an estimated 20%
of allocations by major U.S. institutions.9 More recently, alternative investments have
generally become more accessible, thanks to the introduction of a growing number of
mutual funds and index-based investment vehicles with exposure to alternative asset
classes.10
2 Think globally.
In the years when the U.S., Europe, and Japan had the world’s fastest-growing and most stable
economies, investors tended to focus on opportunities in developed nations.11 But now the most rapid
economic growth is occurring in developing nations that have valuable resources, relatively young and
growing populations, and rising consumer demand. 12

Over the past ten years, sophisticated investors have diversified into both equity and debt instruments of
emerging markets including Brazil, South Africa, India and China.13 They are now turning their
attention to the next tier of developing nations — that is, frontier markets such as Vietnam, Nigeria,
Croatia, and Kuwait. While there are certainly risks associated with investing in undeveloped nations,
their diversity and lack of correlation with other asset classes can help temper those risks, as can
investing through index-based vehicles. The point is that emerging and frontier markets are capturing a
greater share of the world’s growth [Figure 5]. If we are indeed seeing a move to a lower-return global
investment climate, they may be one of the few exceptions.

3 Actively manage market exposure.

Dating back to the 1960s and 1970s, a time when markets were less volatile, the traditional approach to
asset allocation has been to “set it and forget it” with only periodic reassessments. But in today’s
climate, the occasional adjustment may not be enough to protect portfolios from major market
downturns, which historically have tended to be more sudden and violent than the upturns.14 Clearly,
for investors seeking long-term asset growth, sitting on the market sidelines isn’t a solution, either.
What risk-averse investors may wish to explore are tactical strategies that actively and continuously
manage market exposure, allowing them to participate in equity market growth while making an effort
to sidestep the brunt of downturns. Rather than attempting to predict market direction, such strategies

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involve assessing and rapidly responding to market signals. They are designed to be one way for
investors to be nimble and stay flexible, in an ongoing effort to lower the risks of volatility and
investment loss.
THE ULTIMATE QUESTION

How can investors take a more forward-looking approach

 to meeting their goals in a shifting global climate?

While there is no quick fix for the 10% problem, we believe it can be addressed with an updated,
outcome-oriented approach—one that gears portfolios to the outcomes investors want to achieve in the
future, rather than aligning them with methods and assumptions rooted in the past. No longer need
investors think of themselves as being at the mercy of market forces, passively riding the ups and downs.
Instead, investors should know that they (and their advisors) have at their disposal an ever-widening
range of tools that may help increase the probability of meeting their financial goals.

 
1 http://www.econ.yale.edu/~shiller/data.htm
2 Roger C. Altman. “The Great Crash, 2008 - Roger C. Altman”. Foreign Affairs
http://www.foreignaffairs.org/20090101faessay88101/roger-c-altman/the-great-crash-2008.html.
Retrieved Feb 27, 2009
3 Federal Reserve Bank of New York, Historical Changes of the Target Federal Funds and Discount
Rates, as of Feb 19, 2010
http://www.ny.frb.org/markets/statistics/dlyrates/fedrate.html
4 Source: Federal Reserve, Forward Management
5 Standard & Poor’s
6 EnCorr; MSCI
7 Morningstar. Forward Management
8 MSCI; Standard & Poor’s
9 Callan 2010 Alternative Investments Survey
10 Morningstar
11 International Monetary Fund, Strategic Insight, Forward Management
12 International Monetary Fund World Economic Outlook Database, retrieved October 2010
13 Bloomberg businessweek, Pensions & Investments
14 Standard & Poor’s

(c) Forward Management

www.forwardmgmt.com
 
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