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Planning for the Lean Years

If the past two years' losses have lowered your expectations for stock returns, you might want to keep them there -- or even take them down another notch.

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That's the message from financial planners, fund managers and even Warren Buffett. Through the 1980s and 1990s, stocks rang up an 18% average annual gain, according to data from the Charles Schwab Center for Investment Research. That's far above the 11% historical average. The past two years' losses might lead you to expect a surge back to 1990s-type gains. But with a sluggish economy, interest rates due to rise and stocks looking far from cheap, experts are seeing more reasons for stock returns to stay below 11% than above it in coming years.

"If someone came to me and said, 'I have to make 15% a year over the next decade,' I'd tell them there's no way to do it," said Bill Nygren, manager of the (OAKMX) Oakmark fund and the reigning Morningstar fund manager of the year. Citing slower growth and high stock valuations, Buffett wrote that he had "lukewarm feelings about the prospects for stocks in general over the next decade," in his annual letter to shareholders of his holding company, Berkshire Hathaway (BRK.B), last week.

The upshot for fund investors: Sock away more money and expect lower growth. Slimmer gains shouldn't make you abandon stock funds, but they are reason to save more, spread your bets and stick with cheap, tax-efficient funds. If you're prudent now, you'll still reach your goal, and if stocks do exceed your expectations, then you'll be saddled with the pleasant problem of having extra money.

Let's look at why we might see lower gains than we saw in the 1990s and then how we might invest accordingly.

Part of the case for lower gains over the next year are all those gains we've already seen. Yes, stocks have lost ground and trailed bonds over the past two years, but those lousy years cap a stretch of breathtaking gains. Thanks to low interest rates, a solid economy and surging confidence in the equity markets, the S&P 500 gained more than 20% each year from 1995 through 1999, its finest five-year stretch ever. A $10,000 investment in the (VFINX) Vanguard 500 Index fund, which tracks the S&P 500, at the start of this period would've grown to more than $35,000 by its close, according to Chicago research house Morningstar.

"We have to pay for the excessive returns we've seen," says Steve Henningsen of Boulder, Colo.-based financial adviser The Wealth Conservancy. "You just can't get 20% returns year in and year out."

Even with the last two years taken into account, stocks have still averaged a 13% annualized gain over the past 10 and 15 years, through Feb. 28.




What Now?
Experts aren't sure stocks can keep up their white-hot pace
11%, stocks' historical annual return. SSource: Charles Schwab Center for Investment Research.

And though the S&P 500 is down 21% over the past two years, a collapse in corporate profits have kept stocks' valuations far from cheap. The stocks in that index are trading at some 23 times their expected earnings over the next 12 months, according to Thomson Financial/Baseline. That's still well above the index's historical average price-to-earnings ratio , which is about 15.

"I'd say the S&P 500 doesn't look grossly overvalued or grossly undervalued," said Nygren, given current low interest rates and inflation.

If interest rates rose steadily, corporate profits would shrink, making investors less willing to pay up for stocks. The winded state of the U.S. economy will hardly spur companies' earnings or investors' appetite for stocks either.

So it's not surprising that Nygren expects stocks to average a 7% or 8% annual return over the next decade. In today's 10 Questions interview , financial planner Harold Evensky makes a similar forecast. And in Buffett's annual report, the Omaha Oracle disclosed that he expects a 6.3% long-term return for the stocks and bonds mixed in the pensions of companies Berkshire Hathaway owns.

Gloomy as they are, these forecasts aren't reason to quit investing in stock funds. There will undoubtedly be bursts of hot performance for individual stocks and the broader market, too. And there's a dearth of better options out there that you can use to save for retirement. Yes, bonds are less risky, but they usually return less than stocks. Nearly riskless money market funds barely keep up with inflation. So unless you're a real-estate wiz or have come up with the next Pet Rock, you're probably stuck with the stock funds offered in your brokerage and/or 401(k) account.

This creates a potentially dangerous situation. Given the potential for lower gains overall, you might feel the urge to bet the farm on the riskiest fare like emerging-markets stocks, small-cap stocks or high-yield. Each will have their days in the sun and each can play a modest role in your portfolio. But for the vast majority of investors, a lower-return environment is reason to follow the oldest saws in the book:

  • Save more : Lower returns mean you have to invest more to reach your goal.

  • Diversify: Spread your assets across the fund world's sectors and styles, using our portfolio blueprint as your guide.

  • Pay attention to taxes and fees: Index funds and some actively managed funds have a knack for avoiding taxable capital gains distributions and steep fees -- both of which are a lot more noticeable and irritating when you're earning 7% a year rather than 20%.

  • The bottom line is that the only thing worse than losing money on an investment is making far less than you expect or need. Ratcheting down your expectations and ramping up your savings will help keep you out of this nasty bind.

    Ian McDonald writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to imcdonald@thestreet.com, but he cannot give specific financial advice.

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