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Investors expect huge long-term stock returns: 'That's not sustainable,' expert says

"It's essential to understand and manage the risk in your portfolio."

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American investors are feeling optimistic. According to a recent survey from Natixis Investment Managers, U.S.-based investors expect to earn long-term annualized returns of 17.5% above inflation — a huge difference from financial professionals in the same poll, who are expecting above-inflation returns of 6.7%.

Considering that the Fed is aiming for a long-term annual inflation rate around 2%, investors are anticipating a total return that's about twice the 10% historical annualized return of the S&P 500. That's not realistic, experts say.

"You may see returns like that in a given year, but over the long term, that's not sustainable," says Dave Goodsell, executive director of the Natixis Center for Investor Insight. "If you look at what the S&P delivered, there are great years, lean years, and down years. That needs to factor into your plan, because you'll have to take a whole lot of risk to get that kind of return."

Investors, by and large, are willing to take risks, with 6 in 10 saying that they're comfortable doing so to get ahead. But when it comes to the prospect of actually losing money, emotions can take over. Despite their stated appetite for risk, three-quarters of investors worldwide told Natixis that they prefer safety over investment performance.

This self-contradictory mix of attitudes could prove dangerous the next time a big market drawdown rattles investors' expectations, says Goodsell. To avoid making emotional decisions that could hurt your investments, he says, "it's essential to understand and manage the risk in your portfolio."

Here are three ways financial experts recommend doing just that.

1. Understand your risk capacity and tolerance

Everyone wants high returns on their investments. But before you think about optimizing your portfolio for maximum gains, you need to consider your capacity and tolerance for risk. Your ability to financially withstand a major portfolio drawdown is greatly affected by your age and how soon you plan to use the money you're investing.

If you're 20 and investing for retirement, a plunge in the stock market isn't going to derail your goals — your portfolio has plenty of time to recover. But if you're 60 and readying to retire — or 25 and investing a down payment for the house you hope to buy in a few years — the calculus changes. The sooner you need to rely on your investments, the more damage a plunge in your portfolio could potentially cause.

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"Investors need to understand what they can take. We're not all built with the same risk tolerance," says Kelly Mould, senior vice president of the wealth team at Johnson Financial Group. "Sometimes you don't know until you hit troubled times. Allocating your portfolio so you can sleep at night is important. A lot of brokerages have a tool that can help you assess your risk tolerance."

These tools, such as Vanguard's questionnaire, which you needn't be a client to take, will recommend an allocation to stocks and bonds that aligns with your risk tolerance. As a rule of thumb, the higher your tolerance, the more you should be invested in more volatile assets, such as stocks.

If you find that you're more exposed to riskier assets than you thought, it may be time to sell some of your stocks in favor of more staid fare, such as bonds.

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2. Diversify and rebalance your portfolio

Once you have a portfolio that matches your personal risk profile, you can further manage bumpiness in your returns by making sure your investments are broadly diversified. "It's long been considered one of the golden rules of investing," says Corey Walther, president of Allianz Life Financial Services. "People are leveraging the benefits of diversification across various asset classes, including equities vs. fixed income, domestic vs. global stocks, and companies of different sizes."

For a look at how diversification can help cushion your portfolio from sharp falls in any particular type of investment, take a look at investing research firm Callan's Periodic Table of Investment Returns. In 2020, you'd have done best with a portfolio tilted to small-company stocks. But in 2018, those firms lost 11% and were crushed by the likes of cash and bonds.

Having a broadly diversified portfolio gives you the best possible chance that something will always work for you.

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Once your portfolio is set up the way you want it, make sure to revisit it periodically to rebalance back to your target allocations. That way, your portfolio never skews too far toward your biggest winners at the expense of lagging investments that could eventually bounce back.

"You should always be rebalancing and sticking to the plan," says Brad McMillan, chief investment officer for the Commonwealth Financial Network. "Rebalancing is the easiest and most bulletproof way to regularly sell high and buy low."

3. Consider working with a financial advisor

The possibility of losing money is U.S. investors' biggest fear, according to Natixis' survey. But it's not the only one. Coming right behind it was a familiar investor foe: taxes. Inflation fears weren't far behind, either.

Failing to consider the effects of taxes and inflation can take a huge bite out of your investment returns. There are things that individual investors can do to mitigate both, but if this all sounds like a lot to balance, it may make sense to consider working with an investment advisor, says Goodsell.

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"Balancing all of these risks with return is where advisors really earn their fee," he says. "They can help you understand how all the pieces fit together, and guide you away from making emotional decisions."

Financial advisors come with a variety of professional designations and fee structures, so shop around if you're interested in hiring one. Experts generally recommend sticking with fee-only planners, who don't make money through selling you on particular investments. They can be found through groups such as the Garrett Planning Network, the National Association of Personal Finance Advisors, or the XY Planning Network, which specializes in advice for millennials and Gen Xers.

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