Investors should set their sights lower, according to a recent study by McKinsey Global Institute called “Diminishing Returns.”
The report says that 1985-2014 was a golden era for investment returns that is unlikely to be repeated and that investors will need to get used to a world of lower returns. That’s because the confluence of favorable factors that pushed stock and bond returns higher over that period have now run their course.
Among the factors that made 1985-2014 exceptional:
- Inflation fell sharply from double digits in the 1970s to low single digits by the mid-1980s
- Interest rates also fell significantly. In mature economies, real rates on 10-year government bonds fell from 6- 8% in the mid-1980s to an average of 1.7% in 2009.
- Favorable demographics supported economic growth, especially growth in the working age population of 15- 64 year-olds.
- Productivity growth was high and contributed 52% of global growth between 1964 and 2014.·
- The rise of China alone was a massive contributor to global GDP growth.
- Corporate profit margins were exceptionally strong during the period, as millions from emerging markets entered the consumer class. In addition, corporations were able to lower costs dramatically, thanks to technological innovation and access to an enlarged global labor pool.
Now that many of these trends have played out, McKinsey thinks real stock returns over the next two decades could be 2.5% lower than they have been, while real bond returns could be 4% lower.
Of course, McKinsey is hardly alone in its expectation of lower returns. Lower returns have been talked about for a long time — and many thinkers have recognized that the 1980s were a special and easier time to invest.
As one example, hedge fund manager Stanley Druckenmiller said in a recent speech that, “Not only valuations were low back in 1981 but financial leverage was less than half of what it is today. . . [then Fed chairman Paul] Volcker was willing to sacrifice near term pain to rid the economy of inflation and drive reform. The turbulence he engineered led to a productivity boom, a surge in real growth, and a 25-year bull market.”
Today, in contrast, stocks trade at a multiple of 18 times earnings versus 7 times in 1982. Interest rates are near zero or negative, and there are good reasons to believe corporate earnings growth will slow.
So what is an investor to do in this world?
Druckenmiller would say to buy gold. A financial planner would say to control what you can control by saving more aggressively. After all, McKinsey says that if the average annual investment returns are 2% lower, a 30-year old would need to double his or her savings or work seven years longer to live as well.
Mohammad el-Erian, who has long talked about a lower-return world, would suggest not only larger cash allocations, but also “careful name selection” of high-quality companies with strong balance sheets. The best names for buying and holding, he thinks, are those driven by technological innovation.
But perhaps the most interesting idea is to adopt the long-term perspective of Warren Buffett and do nothing at all. Buffett would suggest staying invested and keeping the same practice of buying quality when it’s cheap and then holding forever. After all, he’s done fine in all sorts of eras. At the recent Berkshire Hathaway annual meeting, he said, “We’ve operated under price controls, we’ve had 52% federal taxes applied to our earnings . . . we’ve had regulations come along . . .I think Berkshire will continue to do fine.”