With apologies to Buzz Lightyear, there seems to be a fair bit of cognitive dissonance in the world.  Over the years, advisors have collectively convinced their clients that it would be reasonable to expect high single digit returns on a fairly traditional (say 70% stocks; 30% bonds) portfolio.  I got a call this week from a fellow who told me that, as a former wholesaler for the industry, he “knew” that a 7% to 9% long-term return was a reasonable expectation.  I didn’t have the heart to tell him it isn’t.  Some day soon, I’ll have to break it to him.

What do you suppose has happened to the efficient frontier in the recent past?  As a reminder, the efficient frontier is a concept pioneered by Harry Markowitz in the 1950s: “efficient” because it is optimal and cannot be improved upon; a “frontier” because you cannot go beyond it.  Like infinity. It is the theoretical model of the best return you could plausibly expect for any given level of risk.

Historically, stocks have gotten returns that are about 5% higher than bonds.  Bonds, for their part, have averaged about 3.5% over the post-world war II era.  So, that’s around 3.5% for bonds and 8.5% for stocks.  At a 70/30 split, that’s something like 7% return for a balanced portfolio using historical index returns.  Those are historical numbers.  Of course, if products and financial advice cost (say) 2%, the expected return is more like 5%.

Efficient Frontier has shifted downward

The thing that very few advisors mention, in my personal experience, is that the efficient frontier has almost certainly shifted downward.  Bonds are now more likely to earn something like 1% and stocks, with valuations that are approaching generational highs, are, over the foreseeable future, likely to earn a premium that is less than the 5% historical spread.  Jeremy Grantham at GMO has gone so far as to project that virtually all asset classes have a negative expected return over the next seven years. Continue Reading…