How to think about stock and bond market returns

How to think about stock and bond market returns

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    We often get asked by clients how much their investments will increase from year to year. Although this is impossible to predict accurately, it’s vital to have some understanding.

    Having a reasonable idea of the expected returns of your investment portfolio each year is crucial for retirement planning. It allows you to calculate how much you should be saving for retirement and set a safe withdrawal rate if you are retired or thinking about retiring.  

    We’ve put our financial planning heads together at Heritage to come up with a framework to assess your expected returns in the stock and bond markets. This blog takes you through its key components to get you thinking about the different stock and bond options available to you.

    For more personalised advice based on your goals and circumstances, please get in touch with the Heritage team today. We are independent financial advisors, so you can be sure we will give you impartial advice based on the best rates of return. Fill in our contact form to apply for a free initial consultation here.

    Historical returns and past data

    The past 40 years have been accommodating to equity and bond investors as a result of economic growth and richening asset valuations:  

    Nominal Returns 1978- 2022

    Asset ClassNominal Returns 1978- 2022
    MSCI World Equity Index10.60%
    US Bond Market7.00%

    Source: BacktestbyCurvo

    Had you invested £10,000 into the MSCI World Index in 1978, it would have grown to over £841,832. 

    But this is only part of the story.

    Investors haven’t always had it this easy

    Each year, Credit Suisse look at the historical returns of various asset classes since the 1900s. Here are the long-term returns they have found for various countries

    CountryEquity Real Return 1900 – 2021Bonds Return 1900 -2021
    World ex US4.5%1.7%

    Source: Elroy Dimon, Paul Marsh and Mike Staunton 2022

    With the exception of the US, the long-term returns of both stocks and, in particular, bonds have been lower than returns in recent decades. 

    Looking into the future, Ilmanen argues investors should expect lower returns moving forward as a result of rich valuations, falling bond yields (despite the recent rise in rates to combat inflation) and slower economic global growth.    

    Forecasting stock market returns – Gordon Growth Model

    This model can be applied to any equity or stock market index and has been around for decades. The formula for calculating the expected return is:

    Expected return = dividend yield + growth in earnings + change in valuation. 

    One criticism of the original formula is that by only using the Dividend Yield, share buybacks are not taken into account as a return source, and the expected returns are artificially lower.  As an example, US companies spent $1.2 trillion on buybacks in 2022. 

    Antti Ilmanen of AQR Capital Management modified this formula to reflect buybacks. Rather than use the Dividend Yield, they use the Cyclically Adjusted Earning yield and assume a payout ratio of 50% of earnings.  

    Using the adjustment and assuming growth in earnings of 4.5% (1.50% real growth and 3% inflation) and 5% per annum for emerging markets, with no change in valuations as this is impossible to predict, this gives us the following expected returns for the following markets. 

    Market Nominal Expected Return 
    Global Stock Market7.63%
    UK Stock Market8.07%
    US Stock Market6.35%
    Emerging Market Equities8.57%

    Source: CAPE ratios taken from Idea Farm 

    Comparing the real expected returns with those since the 1900s, an argument could be made to suggest we will see lower returns than what we have experienced in both recent history and the longer-term data.

    Remember, these calculations do not account for any change in valuations. If valuations do change, as some research shops predict, these figures could be a lot worse.

    For example, GMO, who have been particularly bearish on US stocks for many years, believe equity valuations will come down and are forecasting US Large Caps annual returns over the next 7 years will be minus 4.8%!

    Forecasting returns on fixed-income assets

    As a rule of thumb, the Yield to Maturity (YTM) can act as a decent predictor of future bond returns but ignores some of the geekier components of bond returns, such as convexity, which is beyond the scope of this post.    

    This gives us the following expected returns:

    MarketNominal Expected Return
    Global Bond Market3.48%
    UK Gilts Index2.00%
    US Treasury 1-3 years3.91%

    As interest rates have risen dramatically over the past 12 months to combat inflation, the expected returns of fixed income have risen dramatically and are certainly more attractive than it has been in the past 5-10 years.  

    The Classic 60:40 Portfolio

    The 60:40 portfolio, 60% invested in equities and 40% in investment grade bonds, has been one of the best investment strategies in recent decades and provided a diversified portfolio for investors: 

     60:40 Portfolio 1972 – 2022US Stock Market 1972 – 2022
    Compounded Annual Growth Rate9.15%10.29%
    Max Drawdown-27.98%-50.89%
    Worst Year-16.89%-37.04%

    Source: Portfolio Visualizer 

    Over the past 50 years, a portfolio of 60% US equities and 40% US Treasuries has delivered annual returns of 9.15%, only 1.14% less than the stock market, despite having only two-thirds of the volatility and its biggest drawdown half that of the stock market.               

    It is this reason which made it so popular for advisers and individual investors looking for a diversified portfolio.  

    However, looking to the future, its prospects don’t look as rosy (and this is not accounting for a change in valuations).   

    Using the expected returns earlier for 60% global equities and 40% global bonds, we are left with a nominal expected return of under 5.97%. If we assume inflation is 3% per year, this would give you a measly real return of 2.97%.    

    For younger investors with a longer time horizon, this isn’t as much of a problem. However, for retirees or those approaching retirement, this is certainly something to think about. 

    What to do about lower expected returns?

    The boring answer would be to do any of the following; save more, spend less or work longer. Often the simple answer is the most elegant. 

    However, this understandably may not be palatable for most investors or those approaching retirement. 

    Instead, I will focus on what actions investors seeking to increase their investment returns can take:

    1. Simply take more risk and increase your allocation to equities. 
    2.  Look to invest in factors that have historically beaten the broader stock market, such as value stocks.  

    For younger investors with a longer timeframe or investors who have more appetite for risk, one option is to simply increase the equity allocation of their portfolios. 

    If an investor was to take a 70:30 portfolio and if we use the expected returns from earlier, an investor would be left with an expected nominal return of 6.38%.

    The downside of this is that the volatility and drawdowns would increase. For example, a 70:30 US stock bond portfolio since 1972 has seen 4 drawdowns in excess of 20% and the largest in excess of 34% during the Banking Crisis of 2008.

    Why not simply invest all your money in equities?

    I was once asked by a retiree why not invest 100% in equities if he had the risk tolerance and could stomach the volatility of an all-equity portfolio and the higher risk.

    My biggest argument against this is the possibility of a Great Depression period for stocks: 


    Stock Market Returns

    US Ten
    Year Treasuries













    Source: New York University

    Had you invested £100,000 into US stocks alone, this would have been reduced to £35,299 without any withdrawals!

    Admittedly these series of returns are highly unlikely to occur again as there was no ‘fed put’ or central bailing out the stock market like we have seen in 2008 and 2020 during the Covid crisis. At the same time, economic policy was very much ‘Laissez-faire’ with little appetite for intervention, which is very much different than today.

    Invest in Factors

    One approach investors could take to drive higher returns would be to invest in factors or ‘smart beta’. 

    These are factors that have historically proven to have achieved higher returns than the broad stock market benchmarks.  

    These factors include, but are not limited to:

    • Value stocks – those that trade at lower valuations have historically outperformed more expensive companies.
    • Size – smaller companies have historically outperformed larger companies.
    • Momentum – stocks that have recently risen will continue to do so.  

    Reviewing each factor is beyond the scope of this article. Instead, I will focus on combining smaller companies that trade at cheaper valuations – ‘Small Cap value’. 

    What is Small Cap Value?

    Small Cap Value is a term used to describe a particular type of investment strategy. It refers to stocks of small companies with a relatively low market capitalisation that is considered undervalued based on certain fundamental metrics such as price-to-earnings ratio, price-to-book ratio and dividend yield.

    According to data from the Center for Research in Security Prices (CRSP) at the University of Chicago, Small-Cap Value stocks in the United States have returned an average of approximately 13.5% per year from 1926 through 2020, compared to 10.2% for overall stock market (as measured by the CRSP 1-10 Index).

    Although a few percentage points difference does not sound like much, the results above show that increasing your returns by a few percentages, it can make a huge difference.  

    These are the returns we can see since 1972:


    Annual Growth Rate

    of £10,000

    US Stock



    US Small
    Cap Value



    An investment of £10,000 into the US stock market in 1972 would have grown to a very respectable £1.5 million. Had you invested the same amount into Small Cap Value stocks, this would have grown to over £6.5 million!

    Why not invest only in Small Cap Value?

    Looking at the increased returns and final value, it can seem seductive to invest all or a large proportion of your portfolio into Small Cap Value. 

    However, I would caution against this:

    Firstly, they are more volatile. The maximum drawdown of this portfolio was over 55% during the Global Financial Crisis. Not many investors could stomach this and remain invested:

    drawdowns of small cap portfolio

    The value premium is prone to periods of underperformance. Data from Morningstar found that, from 2010 to 2021, large growth stocks returned 492% compared to 181% for small cap value. To capture this premium, investors must be prepared to wait decades. It is all to common for investors to invest in factors and after a few years of underperformance, abandon the strategy just before performance picks up.

    To capture this premium, investors must be prepared to wait decades. It is all too common for investors to invest in factors and, after a few years of underperformance, abandon the strategy just before performance picks up. 

    As this premium is so well known, there is no guarantee the premium will exist in the future and could be arbitraged away as investors chase returns. 

    What is a sensible allocation to Value or Small Cap Value?

    In Rick Ferri’s ‘Core 4’ portfolio for investors who wish to allocate towards small cap value, he recommends an allocation of 12% of the equity allocation is appropriate.   

    In his excellent book Smarter Investing, Tim Hale suggests an allocation between 10% – 20% of the equity sleeve. 

    How to allocate your assets between stocks and bonds using a 65:35 portfolio

    In this example, let’s assume an asset allocation of 65:35 global stocks and bonds, but within the equity sleeve, 20% will be allocated to Small Cap Value.

    Although the premium or excess return for Small Cap Value has historically been 5%, we will err on the side of caution and assume a premium of 3%.

    Using this example, we would be left with the following expected returns:

    Asset Class  Allocation  Nominal Expected Return
    Global Equities52%7.63%
    Global Small Cap Value Equities13%10.63%
    Global Bonds35%3.48%
    Total 100%6.57%

    By making this adjustment, it increased the expected returns by 0.60%, to 6.57%, without taking too much risk and increasing the volatility. 

    Maximise your investments with advice from Heritage Financial Planning

    The stock market can be an unnerving place if you don’t have the right advice, especially if you are approaching retirement or don’t have much appetite for risk. We hope that you have found this blog informative and helpful in making decisions about the future of your stocks and bonds investment portfolio.

    At Heritage, we completely understand the concerns that many people have about investing in stocks and bonds. We are here to provide impartial advice based on your individual circumstances and goals.

    Our only motivation is to help our clients achieve the best return on their investment. We simply wouldn’t recommend an investment we weren’t prepared to make with our own money.

    To arrange a free initial consultation, please fill in our contact form.

    FAQs about stock and bond market returns

    To learn more about stock and bond market returns, check out our frequently asked questions below or contact us today:

    What is an aggregate bond index?

    An aggregate bond index is a benchmark that measures the performance of a diversified portfolio of fixed-income securities, such as government bonds, corporate bonds, municipal bonds (in the US) and mortgage-backed securities. The index provides investors with a broad overview of the bond market’s performance.

    What are equity securities?

    Equity securities represent ownership interests in a company, typically in the form of common shares or stocks, which entitle UK investors to a proportionate share of the company’s profits and voting rights, allowing them to participate in the company’s growth and decision-making processes.

    Are stock market returns more volatile than bond market returns?

    Stocks are more volatile than bonds as they are ownership stakes in real businesses, and their share prices will be dependent on many factors, such as company performance and wider economic conditions.

    Bonds or fixed-income securities are essentially a loan to a company or government. The bond issuer repays both the coupon payment, the initial loan amount and interest payments at maturity.

    If they are investment grade bonds such as a UK government gilt*, then the chance of default is low, which means the risk of default is much lower than stocks, and their return streams are much more predictable.

    *Gilts are lower-risk bonds issued by the government, known as a “gilt-edged security”.

    What happens to stocks and bonds when interest rates rise?

    Interest rates and share prices tend to move inversely. When interest rates rise or ‘tighten’, this can cause stock markets to fall as it suggests a potential economic slowdown.

    However, when interest rates fall, this tends to be good news for stock prices, as we have seen since 2007/8 when the Federal Reserve and other central banks’ monetary policies cut interest rates and undertook Quantitative Easing, which contributed to the bull market of 2009-2022.

    Interest rates and bond prices also have an inverse relationship. When interest rates rise, bond prices fall and vice versa.
    When bond prices fall, this means higher yields and future returns, which can make fixed-income securities a more attractive asset class – although this is bad news for existing owners of bond portfolios.

    In summary

    When assessing expected returns in the stock and bond markets, it’s important to understand historical returns but also the current market conditions and future expectations. There are a myriad of factors that can have an impact, such as dividend yield, earnings growth, and valuation changes.

    To improve the performance of your diversified portfolio, you can consider strategies such as investing in value stocks, small-cap value investments, or simply taking on more risk. Remember, your expected returns have a direct impact on your retirement plan, and so it’s wise to get professional advice before making investment decisions.

    The value of your investments can go down as well as up, so you could get back less than you invested.

    The information contained within this article is for guidance only and does not constitute advice which should be sought before taking any action or inaction

    If you’re interested in learning more about stocks and investing, read our informative blogs here:

    Alex Norman-Jones​

    Alex Norman-Jones​

    I am one of the founders of Heritage and I am highly motivated to deliver bespoke financial planning solutions to my clients.

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