Following is an analogy to explain how to think about expected return and what actions might be prudent if that expected return changes.
The Magic Box. Imagine there is a magic box and at the end of each year a dollar mysteriously appears inside. Suppose you pay $10 to acquire this box. At the end of the first year, it produces the aforementioned dollar as it always has. What is your expected return on your investment? Well, if you continue to receive $1 per year on an investment of $10, then you have a 10% return ($1 return divided by a $10 investment). At the end of the first year, after collecting your dollar, you sell the box to someone else for $20. What has been your actual return? You received 10% from the dollar produced, and an additional $10 (100%) from your gain on the sale, so your total return was 110% ($11 total profit divided by $10 cost) for the year.
So far, so good, but now it gets a little more complicated. What is the expected return for the person who bought the magic box from you? One way he or she might look at it is that the box has “always” produced 110% return per year for as long as we have historical data. Therefore, we should expect 110% each year in the future. Many people do this with the stock and bond markets and simply look at the historical total returns that have been achieved to arrive at an estimate of future returns.
Some analysts go a step further and suggest that price appreciation (P/E multiple expansion) may not continue as it has, so we should remove the 100% appreciation from the total return leaving us with 10% expected return. This seems plausible until we realize that the person who bought the box from us paid $20 and will likely receive $1 per year for a 5% return. Of course someone may in the future purchase the box for $30 or $10, we simply don’t know in advance. Historically, the stock market has paid about $15 for a dollar of earnings; currently it is slightly higher than that. That does not necessarily imply that the market must go down, but it does imply some probability of lower returns in the future. In general, I believe that markets work, and current prices are the best estimate of future prices.
Two Boxes. Now let me change the example slightly. Suppose there are two types of magic boxes. One works just like the one in the previous example. It magically produces $1 each and every year like clockwork. We will call that box the “bond box.” The second box type on average creates $2 per year, but it is highly uncertain. Some years there is nothing, some years there is more than $2, but on average it has been about $2 per year. We will call this box type the “stock box.” Due to the uncertainty of the stock box, both of these boxes cost the same amount. In other words, you can choose to purchase a bond box and get $1 per year or purchase a stock box and on average receive $2 per year but at irregular intervals. Given this scenario, suppose you choose to buy equal numbers of each box to reduce your risk a little but get returns higher than $1 per year. On average, you will receive $1.50 per box with some uncertainty due to the stock boxes.
Now suppose that it appears that the stock box, instead of producing $2 per year on average, is only producing $1.50 per year on average. It may be hard to tell due to the irregularity of the pattern, but suppose we are convinced that it is now $1.50 and not $2.00. What should you do?
As with many questions, it depends. If you absolutely, positively must average $1.50 per year return as you always have, you have no choice but to sell all of your bond boxes and buy stock boxes. That is the only way to get $1.50 on average. Of course, you will have a lot of risk given the irregularity of the payments, but on average (a very important caveat) you will receive the $1.50 you always have.
Another option is to look at it another way. You previously received a premium of $1 per stock box for taking the risk that in any given year you might get nothing at all. Now you are only getting $0.50 premium for taking that same risk. It would seem logical to have more bond boxes in that case since you aren’t getting as much compensation for that risk. Looked at from this perspective, it would be rational to have fewer stock boxes and more bond boxes. Of course your expected return is lower than it would be otherwise, but so is the risk.
Which adjustment to make (more risk or less risk) will depend greatly on your individual situation.