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Historical returns are no guarantee for the future, but may give some idea how things might turn out over the long-term. On average, the annual returns for liquid reserves such as money market funds have been about 5%, while those for intermediate bonds were about 6%, and those for equities were about 10.5%, if one includes their dividends. Thus, if one puts together a portfolio that focuses, on average, on about 65% in relatively higher yielding stocks and mixes them in with 5% in the better yielding liquid reserves, and about 30% in a good, low-cost bond index mutual fund, such as Vanguard Total Bond Index Fund, and if the returns match those obtainable previously, a long-term, compound, annual total return of about 8% is possible (after "frictional costs"), with relatively little overall volatility, particularly if one rebalances each year or after equity swings of 10% or more.
But the current situation is somewhat unusual in several respects. To begin with, money market funds are now yielding not 5% but about 1.5%. Then, the federal reserve cannot lower interest rates much more. The fed. funds rate is already less than 2%, or about the lowest it has been in forty or more years.
The average (intermediate) domestic bond yield is only about 4% after expenses. But the total return on most bonds is determined not only by their coupons, dividends, or yields but also by their price, which, in turn, responds to factors like inflation and the direction of interest rates. Some bonds will rise or fall 12% for each 1% the interest rates fall or rise, respectively. Zero coupon bonds and some high-yield or junk bonds rise and fall with much more volatility. Some long-term zero coupon bonds could fall 25% or more in response to a rise in interest rates of 1%.
Since the fed. funds rate cannot go much further down, it seems reasonable that at some point in the foreseeable business cycle they will need to begin to rise again, with the predictably negative effects on bond returns.
At the same time, also looming dimly on the horizon are some signs that inflation may be returning in the next few years. Perhaps the major indication of this is that, since September 11, 2001, all of the hard-fought fiscal responsibility that had been achieved in the 1990s has been discarded in favor of multi-billion dollar spending sprees for a war on terrorism, homeland security, aid to farmers, aid to airlines, and a host of other pet projects to keep the voters happy with what the incumbents are doing, so they can be reelected. At the same time that spending has mushroomed, taxes have fallen. Therefore we now again have projections of large federal deficits instead of the surpluses that were so touted just a couple years ago.
Unfortunately, to pay for debt, whether at the federal, state, or local level (and state and local governments are, if anything, having even larger burdens now), more money must be printed, which is inflationary and which also adversely affects the return of bonds.
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