Portfolio Management | May 2, 2021

Why Market Returns May Be Lower and Global Diversification More Important in the Future

Market returns on stocks and bonds over the next decade are expected to fall short of historical averages, according to our 2021 estimates.¹This article provides a broad overview of the methodology used for calculating our capital market return estimates and highlights the importance of diversification and staying focused on long-term financial objectives that are based on reasonable expectations.

The main factors behind the lower expectations for market returns are historically low interest rates, tepid long-term economic growth prospects, and elevated equity valuations.

The reduced outlook follows an extended period of double-digit returns for some asset classes, as shown in the chart below. As such, now may be a good time for investors to review, and consider resetting, long-term financial goals to ensure that they are based on projections grounded in disciplined methodology rather than on historical averages.

Curb your expectations

Total return = price growth plus dividend and interest income. The example does not reflect the effects of taxes or fees. Numbers rounded to the nearest one-tenth of a percentage point. Benchmark indexes for the asset classes: S&P 500® index (U.S. Large-Cap Stocks), Russell 2000® (U.S. Small-Cap Stocks), MSCI EAFE Index® (International Large-Cap Stocks), Bloomberg Barclays U.S. Aggregate Bond Index (U.S. Investment-Grade Bonds), and Citigroup 3-Month U.S. Treasury Bill Index (Cash Investments). Historical inflation is based on Consumer Price Index for All Urban Consumers, published by U.S. Bureau of Labor Statistics. Past performance is no guarantee of future results.

Source: Charles Schwab Investment Advisory, Inc. Historical data from Morningstar Direct. Data as of 12/31/2020.


Our estimates show that, over the next 10 years, stocks and bonds will likely fall short of their historical annualized returns from 1970 to December 2020. The estimated annual expected return for U.S. large-capitalization stocks from January 2021 to December 2030 is 6.6%, for example, compared with an annualized return of 10.8% during the historical period. Small-capitalization stocks, international large-capitalization stocks, core bonds, and cash investments also are projected to post lower returns through December 2030. We find the same pattern with real returns for these investments (i.e., returns after removing the effect of inflation). Which suggests that the reasons for this are more complex, and rest on the fundamental drivers of economic growth.

Expectations of rising inflation have been on many an investor’s mind lately. The reasons are understandable, especially due to the Federal Reserve’s current accommodative monetary policy as a response to the aftereffects of the pandemic on the economy. As the economy opens up and demand ramps up ahead of supply chains coming online, there could be increased inflationary pressures in the near term, but we do not believe this extends to the long term. As the economy readjusts, and we look toward the long term, we expect future inflation to remain benign at 2.1%. This is based on consensus estimates of leading economists, and is quite a bit lower than historical inflation, which has averaged 3.9% since 1970. The impact of inflation can be felt across asset classes, but most adversely in case of cash and bonds.

Cash expected returns are expected to remain low. Monetary policy, combined with investors’ flight to safety, has caused bond term premiums—that is, the difference between the yields earned by locking up money over an extended period vs. rolling over a short-term instrument (like Treasury bills) for the same period—to turn negative. This suggests that bond returns are also likely to remain subdued.

Here are answers to frequently asked questions about these market estimates:

Why are long-term estimates of returns important?

A sound financial plan serves as a road map to help investors reach long-term financial goals. To get there, investors need reasonable expectations for long-term market returns.

Return expectations that are too optimistic, for example, could mislead investors to expect their investments to grow at an unrealistically high rate. This may cause them to save less, in the hope that their investments might grow large enough to fund their retirement or big expenses. But when actual returns do not match these expectations, it could lead to a delayed retirement or make it difficult to pay for a big expense, such as a college education. On the other hand, if return expectations are overly pessimistic, too much may be saved in the nest egg at the expense of everyday living.

How do you calculate your long-term forecasts?

The long-term estimates cover a 10-year time horizon. We take a forward-looking approach to forecasting returns, rather than basing our estimates on historical averages. Historical averages are less useful, as these only describe past performance. Forward-looking return estimates, however, incorporate expectations for the future, making them more useful for making investment decisions.

For U.S. and international large-cap stocks, we use analyst earnings estimates and macroeconomic forecast data to estimate two key cash-flow drivers of investment returns: recurring investment income (earnings) and capital gains generated by selling the investment at the end of the forecast horizon of 10 years. To arrive at a return estimate, we answer the question: What returns would investors make if they bought these assets at the current price level to obtain these forecasted future cash flows?

For U.S. small-capitalization stocks, we forecast the returns by analyzing and including the so-called “size risk premium.” This is the amount of money that investors in small-capitalization stocks expect to earn over and above the returns on U.S. large-capitalization stocks.

For the U.S. investment-grade bonds asset class, which includes Treasuries, investment-grade corporate bonds and securitized bonds, our forecast takes into account yield-to-maturity of a risk-free bond, roll-down return, and a credit risk premium.² We believe the future level of return an investor will receive is anchored to a large extent by the yield of a 10-year U.S. Treasury bond. Treasury bonds are generally considered to be default-risk-free. Aside from this, roll-down return is an additional source of return bond fund investors typically earn, as they almost always invest in a bond portfolio that is designed to maintain an average maturity. For example, a roll-down return occurs when a bond fund manager sells a bond whose maturity falls below the average maturity of the portfolio. This process typically results in a gain because yields on bonds with longer maturities are usually higher than on shorter maturities, and because bond prices rise when yields fall. Credit risk premium is the return an investor earns for taking on the risk of default, as when investing in a relatively riskier bond, such as a corporate bond.

Cash investments are very short-term in nature, typically not exceeding three months at a given time, and are reinvested at the end of each period for as long of a horizon as desired. We assume this horizon to be 10 years and estimate the returns from cash investments over this period using a term premium model.

Why do you expect long-term returns to be lower than historical averages?

Three primary factors are behind the forecast for reduced returns: low interest rates, low economic growth, and equity valuations.

  • Low interest rates. Lower inflation affects yields on everything from cash to 30-year Treasury bonds. As noted earlier, inflation is low by historical standards and expected to remain so over the next 10 years. When the rate of inflation is low, nominal bond yields also have been low. That is because bond investors generally do not require as much yield premium to compensate for the erosion in buying power that inflation can inflict on a portfolio. Nominal bond yields are the yields that investors typically notice and does not remove the impact of inflation, as real yields do. Current and expected interest rates are much lower than what has transpired historically, especially compared to the high-interest-rate environment of the 1980s. The Fed has once again started following a zero-interest-rate policy in response to the economic fallout due to COVID-19. Low yields mean investors earn less from the fixed-income portion of their portfolios.
  • Low economic growth. Economic growth and inflation typically go hand in hand. Strong economic growth typically causes rising inflation, as demand grows faster than supply. Inflation induced by growth is a good thing, as asset returns also tend to increase. At present, while near term economic growth is likely to be robust, as the economy opens up (post-pandemic), consensus forecasts of economic growth over the long term remain subdued. A measure of economic growth is annual real gross domestic product (GDP) growth. A robust economy is fundamental to achieving healthy returns from the financial markets. Everything from monetary policy, to interest rates and company earnings are linked to this. According to consensus forecasts, economists expect 2.3% GDP growth per year, on average, over the next 10 years, even after accounting for expectations of increased economic activity post-pandemic. This compares to historical average GDP growth of 3.1% per year (since 1948).
  • Equity valuations. Valuations appear to be stretched compared to last March’s levels. While earnings growth is expected to remain strong in the medium term—as the economy starts to get back to normal post-pandemic—the stock rally since last March has run far ahead of these expectations. High stock prices today, without a proportionate increase in future earnings, mean lower expected returns going forward. But stocks still tend to have higher expected returns than bonds, as they generally have higher risks.


What could lead to higher returns?

Returns could exceed our expectations if the U.S. economy grows more than economists anticipate. Higher-than-expected economic growth would likely lead to higher earnings growth, driving stock and bond returns higher. An example of the economy growing faster than expected occurred from 1990 to 1999. During that period, economists expected annual GDP growth of 2.4%, while the U.S. economy grew at a much higher rate of 3.4% annually on average. Corresponding returns from U.S. large-capitalization stocks were 18.2% on average and core bonds averaged 7.7% despite severe market turbulence in 1998.

What can investors do now?

Thanks to the power of compound returns, what investors do (or don't do) today can have big implications on their ability to meet their long-term goals.

Here are a few things to consider doing. First, if you don't have a long-term financial plan, now is a good time to put one together. Second, try to minimize fees and taxes, particularly in a lower-return environment. And last but not least: Build a well-diversified portfolio.


1 Charles Schwab Investment Advisory, Inc., a separately registered investment advisor and an affiliate of Charles Schwab & Co. Inc., annually updates the capital market return estimates.

Treasury notes generate what is considered a “risk-free” rate, or yield, because of the negligible chance of the U.S. government defaulting on its debt obligations. A corporate credit “risk premium” is the amount of money that investors expect to earn above and beyond the yield because of the chance of a default by the corporation that issued the bond.

What You Can Do Next