ETF Mistakes: Unrealistic Expectations and Inflation

Inflation and expectations of market returns can influence your portfolio negatively if you forget to take them into account. When building your ETF portfolio and planning your financial future, take care that you remember to consider these two factors.

Unrealistic expectations of market returns

One reason many people don’t save enough is that they have unrealistic expectations; they believe fervently that they are going to win the lottery or (next best thing) earn 25 percent a year on their investments.

The truth: The stock market, over the past 80 years, has returned nearly 10 percent a year before inflation and 7 percent a year after inflation. Bonds have returned about 5 percent before inflation and 2 to 3 percent after inflation. A well-balanced portfolio, therefore, may have returned 7 or 8 percent before inflation and maybe 5 percent or so after inflation.

Five percent growth after inflation — with interest compounded every year — isn’t too shabby. In 20 years time, an investment of $10,000 growing at 5 percent will turn into $26,530 in constant dollars.

Most of us in the investment field expect future returns to be more modest. But with a very well-diversified, ultra-low-cost portfolio, leaning toward higher-yielding asset classes, you may be able to do just as well as Mom and Dad did. If you want to earn 25 percent a year, however, you are going to have to take on inordinate risk.

Discount the negative effect of inflation

No, a dollar certainly doesn’t buy what it used to. Think of what a candy bar cost when you were a kid. Think of what you earned on your first job. Are you old enough to remember when gas was 32 cents a gallon?

Now look into the future, and realize that your nest egg, unless it’s wisely invested, will shrivel and shrink. Historically, certain investments do a better job of keeping up with inflation than others. Those investments, which include stocks, tend to be somewhat volatile. It’s a price you need to pay, however, to keep the inflation monster at bay.

The world of ETFs includes many ways to invest in stocks, but if you find the volatility hard to take, you might temper it with a position in Treasury Inflation-Protected Securities (TIPS). The iShares Barclays TIPS Bond Fund (TIP) tracks an index of TIPS.

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Source:http://www.dummies.com/how-to/content/etf-mistakes-unrealistic-expectations-and-inflatio.html