Don't bank on earning an annual return much in excess of 7% on the U.S. stocks allocation in your portfolio. That was the message almost two years ago, when I forecast an annual return for the S&P 500 of 7.2% over the next seven years. Two years on, and the expected return over the next seven to 10 years has hardly budged at all. But what do I know about predicting stock returns? Instead, let's listen to an authority, Vanguard's Jack Bogle.

Bogle sets the record straight
In an interview published on Morningstar's website on Aug. 12, this is what Bogle had to say about the prospects for stocks over a 10-year horizon (with the S&P 500 at almost exactly the same level it closed at Friday):

Stocks could give you a return significantly higher than that [of Treasury bonds.] Stocks also have a yield of around 2.3%, the same as the 10-year Treasury, but they have earnings that should grow even if the economy grows a little more slowly, let's say it's 4% instead of 5% in nominal terms, that would be a 6% return on stocks. Maybe they can grow a little faster. That would be a 7% return on stocks for example, unless P/Es change radically.

Bogle's arithmetic
In order to produce a return forecast, Bogle breaks stock returns into three components: income return (dividends), earnings growth, and change in valuation (the earnings multiple the market is willing to pay for future earnings). This is his arithmetic:

Stock Returns -- Components

 

Dividend return

2.3%

Earnings growth

4%-5%

Change in P/E multiple

0%

Estimated 10-year annualized return

~ 7%

(My return forecast assumed the S&P 500 at 1,057.08 -- a 15% overvaluation. On the date of Bogle's interview, the overvaluation was 23%. The difference between the two is insignificant in terms of the impact on annualized return forecasts (seven-hundredths of a percentage point, if you're wondering.)

The absolute truth
Although Morningstar put a happy face on Bogle's words with the title "Bogle: Stocks Poised to Outperform," he made a second, critical point toward the end of the interview. While the first part of the discussion focused on the prospects for stocks' relative performance, Bogle then shifts toward his analysis of stocks' absolute performance. Here, Bogle sounds a more cautious note:

So, I'd like to look at potential returns. But I also like to think of the consequences ... if things go wrong, so we can call it some dry powder or we can call it a little formula for sleeping better at night when you go through these volatile times.

Expect the unexpected
Translation: The expected return isn't the return you should expect. Let me explain. The future is uncertain; the expected return may be the highest likelihood return, but stock returns are sufficiently volatile -- even over a 10-year period -- that it is highly probable that your actual returns will differ from them. Since the modern S&P 500 was introduced in March 1957, the average annual return over a 10-year period is 6.8% (incidentally, this is the midpoint of Bogle's range). However, the standard deviation is five full percentage points. In other words, even if Bogle's estimate is correct, the odds of a return lower than 2% is roughly 1 in 6! That scenario is what Bogle is referring to when he says that things can "go wrong." It's not that unlikely.

However, there are ways to mitigate that risk, the most effective of which is to require a margin of safety when you invest. When your expected return is only 7% -- roughly three percentage points less than the long-term historical average for U.S. stocks -- you don't want to be overweight stocks. On the contrary, you should be underweight and, in an environment in which the 10-year Treasury yields little more than 2%, that means holding cash. (I'm reasoning here with regard to the U.S. allocation of your portfolio.)

5 above-average stocks and 5 below-average
That advice holds for index-oriented investors. If you fancy yourself a stock picker, you have the option of trying to select stocks that look likely to beat the index. Of course, if you go that route, there is always the risk that you choose stocks that fall short of the market return because their prospects don't justify their valuations. The following table contains 10 stocks that I categorize in one or the other category:

Above-Average Expected Return (>7%)

Below-Average Expected Return (<7%)

Berkshire Hathaway (NYS: BRK.B) Allied Nevada Gold
Google AutoNation
Microsoft (NAS: MSFT) Green Mountain Coffee Roasters (NAS: GMCR)
PNC Financial (NYS: PNC) LinkedIn (NAS: LNKD)
Zimmer Holdings (NYS: ZMH) salesforce.com (NAS: CRM)

Source: Capital IQ, a division of Standard & Poor's.

Owning the average means earning the average
Let me sum up: If you hold broad market index funds or a broadly diversified portfolio of stocks, and you trust Bogle's assessment, you should expect to earn roughly 7% over the next seven to 10 years. This assumes 2%-3% annual inflation; above that level, the expected rate would need to be revised upward. If you want to earn more than that, you're going to need to place some bets by putting together a portfolio of stocks that differs materially from the index. One of the best areas to look for those wagers right now is high-quality, large-cap stocks (such as the ones in the first column of the table above). If you want more high-quality names, the Fool has identified 13 High-Yielding Stocks to Buy Today.

At the time this article was published Fool contributor Alex Dumortier holds no position in any company mentioned. Click hereto see his holdings and a short bio. You can follow him on Twitter. The Motley Fool owns shares of PNC Financial Services Group, Microsoft, Zimmer Holdings, Berkshire Hathaway, and Google. Motley Fool newsletter services have recommended buying shares of Microsoft, Google, salesforce.com, Green Mountain Coffee Roasters, and Berkshire Hathaway. Motley Fool newsletter services have recommended creating a bull call spread position in Microsoft. Motley Fool newsletter services have recommended creating a lurking gator position in Green Mountain Coffee Roasters. Motley Fool newsletter services have recommended shorting salesforce.com.Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.


Increase your money and finance knowledge from home

Investing Like Warren Buffett

Learn from one of the world's best investors.

View Course »

Bonds for Beginners

Learn about fixed income investments.

View Course »

Add a Comment

*0 / 3000 Character Maximum