In Charles Dickens’ famous book Great Expectations, the leading character Pip’s “great expectations” of being a wealthy gentleman were quickly extinguished when his benefactor Magwitch died. Under English law, Magwitch’s wealth was forfeited to the crown instead of to the hopeful Pip.

Like Pip, investors may find that their great expectations may end up in great disappointment. In a recent article in the Wall Street Journal by Jason Zweig titled: “Why Many Investors Keep Fooling Themselves”, January, 16, 2010, Mr. Zweig
wrote that “a nationwide survey last year found that investors expect the U.S. stock market to return an average of 13.7% over the next 10 years”.

According to Mr. Zweig, investors are not considering the impact of inflation, investment expenses and taxes on investment returns. He states that those costs will typically reduce investment returns by as much as five to seven percent (three percent for inflation and one to two percentage points each for expenses and taxes). As a result, a 13.7% gross return would net out at around 6% to 8%. And that assumes a 13.7% return for stocks is realistic. The long-term return for stocks has been around 10%. Reducing that by 5% to 7% would leave one with a net return of 3% to 5%.

Going forward, we question whether we can expect the 10% stock returns that have historically occurred. We still have a rough road ahead to recover from the current economic crisis. We can still expect a large number of residential foreclosures during 2010 as well as many commercial real estate defaults. Many are concerned that increased government spending will lead to higher taxes, higher interest rates and high inflation. If so, it’s not difficult to imagine another recession not too far down the road.

In the research for his article, Mr. Zweig asked four investment experts what “guaranteed net-net-net return they would accept to swap out their own assets”. The experts, including Vanguard Group founder John Bogle, quoted returns ranging from as low as 0.5% to 4%.

To make matters worse, if you maintain a diversified portfolio (which we strongly suggest), you can expect your non-stock asset classes to return less than stocks. This will reduce your portfolio risk but will also lower your overall net return even more.

Excessively high expectations for returns can lead one to chase the latest hot asset classes or the false promises of the next Ponzi scheme. So what can you do? Make sure your portfolio is broadly diversified and rebalanced regularly. Focus on minimizing investment expenses and taxes and pay close attention to the other areas of your finances that you can impact. Your overall wealth is a function of many factors, some of which you can control, such as credit card debt, savings and spending. Be realistic about your stock returns, focus on those things you can control and you will lessen the chance of being disappointed down the road.