Are You Prepared for a 3% Stock Market Return?

Following a day on which stocks were broadly flat, they're sliding this morning, with the S&P 500 (SNPINDEX: ^GSPC  ) and the narrower, price-weighted Dow (DJINDICES: ^DJI  ) down 0.15% and 0.33%, respectively, as of 10 a.m. EST.

The long view
Investment bank Credit Suisse published its Global Investment Returns Yearbook (link opens PDF) on Tuesday. This is a first-class piece of sell-side research -- virtually unique, in fact. For one thing, the focus is on long-term outcomes, not what the market will do today or next week, which is unknowable. Furthermore, the report's authors aren't even Credit Suisse analysts, but a trio of distinguished London Business School academics: Elroy Dimson, Paul Marsh, and Mike Staunton ("DMS" hereafter), who are authorities on global long-run stock returns.

The report is a trove of interesting research and data, but the title of the first chapter, "The Low Return World" sums up the dilemma investors currently face. DMS estimate that U.S. equities are set to deliver an annualized return, after inflation, in the range of 3% to 4% over the next 20 to 30 years. They obtain their forecast by adding an equity risk premium averaging 3.5% to a real-cash return -- i.e., the return on Treasury bills, adjusted for inflation -- that they expect to be roughly zero. Clearly, if that turns out to be accurate, it will be a problem for individual investors and pension funds that expect to earn 6% or more.

So what's an investor to do? DMS identify some ways that may enable investors to earn an incremental return:

To exploit stock market predictability, investors should take advantage of opportunities when returns are expected to be higher, and hence should buy when prices are low relative to fundamentals. In historical terms, that means buying enthusiastically during the October 1987 crash, during the Lehman crisis, and during other major setbacks; and selling outperforming assets during the 1990s bull market.

Nevertheless, they recognize such a contrarian strategy is difficult to implement. As such, they suggest a mechanical approach as one option: "It can be useful to follow a dollar-cost averaging approach, whereby regular investments are made into a portfolio, so that at least some assets are bought at the bottom (and relatively fewer at the top)."

It's not sexy, but it works.

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