Tuesday May 15, 7:00 am ET
By Christopher Davis

What do stocks return on average? Most investors probably would answer 10% or more per year. It's not as if this expectation isn't grounded in fact: Between 1926 and 2001, stocks returned 10.2% annually according to Stocks for the Long Run author Jeremy Siegel.
 
Past performance isn't always indicative of future results, however. There's nothing saying that 10% annual returns are investors' birthright. Market pessimists argue that the stock market is still expensive by historical standards, limiting investors' upside potential. Falling interest rates throughout the early 2000s provided a tailwind that stocks don't enjoy now, and corporate profits are currently at all-time highs. Moreover, they worry about the long-term health of the U.S. economy, which is saddled by huge budget and trade deficits. Both deficits are heavily financed by foreign capital. Foreign investors could decide to take their money elsewhere, possibly sending interest rates upwards and the dollar lower.

So if the pessimists are right and stocks are headed for an extended period of underperformance, what should investors do? Here are some ways to invest well in a low-return world.

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Even modestly below-average stock market returns could leave you with a big hole to fill. If stocks return an average of 10% per year over the next 25 years, a $10,000 investment would turn into $108,347. But if average annual returns fell to 8%, that $10,000 would be worth $68,485. Over a quarter century, a 2-percentage-point difference in annual returns leaves you with portfolio nearly 40% smaller than it would have been otherwise. If returns average just 5% per year, the scenario becomes even bleaker: $10,000 becomes just $33,864.

The only way to fill this gap is to sock more of your paycheck away in savings. The best place to start could be your 401(k). If your employer matches your contributions, be sure you're taking full advantage. If you're not, you're leaving free money on the table and making it more difficult to build your nest egg.

Pay Close Attention to Costs
While there's no way to control the stock market, you can control how much of its returns expenses eat up. In a low-return environment, costs will consume a larger portion of your potential gains than they did in the 1990s, when stocks were up double digits almost every year. If you own a mutual fund with a 1.5% annual expense ratio and its manager matches the stock market's 20% return before expenses, you're still left with 92% of the market's return after expenses--a not-too-shabby 18.5% gain. But let's say stocks return just 8% a year. After expenses, you'd pocket 6.5%, losing nearly 20% of the stock market's return along the way.

You can easily avoid sacrificing a large portion of the stock market's returns by investing in low-cost equity index funds, such as those offered by Vanguard and Fidelity, whose annual expense ratios weigh in at 0.2% or less. Proponents of active management might argue the prospect of subpar stock market returns weakens the case further for indexing. But active managers burdened by high costs are likely to fare even worse than the below-average results posted by the indexes. Savvy stock-pickers can outpace indexes, but only bet on those with low expense hurdles to overcome. For actively managed stock funds, stick with funds that have expense ratios below 1.0% a year, though even cheaper is better. Our list of Analyst Picks, available to Premium Members of Morningstar.com, is replete with ideas.

Similarly, stock investors should resist the temptation to trade a lot. Even if you stick with discount brokerages, commissions add up, taking a bite out of your returns. Remember that mutual funds have to pay trading costs, too, so fund investors should stick with low-turnover strategies.

Limit the Tax Collector's Bite
Limiting Uncle Sam's take is important for the same reason as keeping a lid on expenses. Taxes can take a big toll on returns. In fact, the SEC estimates taxes have wiped out 2.5 percentage points of the average mutual fund's annual returns.

Fortunately, just as you can with expenses, you can minimize the impact of taxes. First, make full use of tax-advantaged vehicles like individual retirement accounts and your 401(k). (To learn more about what investments are best suited for IRAs and other nontaxable accounts, click here.)

Outside of those nontaxable accounts, hold investments that won't generate a lot of tax-unfriendly capital gains and dividends. Aggressive, momentum-driven growth funds can be a nightmare from a tax standpoint. Those offerings tend to trade rapidly in and out of stocks, generating a lot of capital gains in the process.

Instead, hold individual stocks in your taxable accounts (because you control when you realize capital gains and losses) and focus on funds that keep turnover low and keep tax efficiency in mind. Tax-managed funds such as Vanguard Tax-Managed Capital Appreciation (NASDAQ:VMCAX - News) and Vanguard Tax-Managed Growth & Income (NASDAQ:VTGIX - News), which provide tax-friendly spins on the Russell 1000 and S&P 500 indexes, respectively, are excellent choices for taxable accounts. Even funds without tax-managed mandates can work well. Oakmark isn't a tax-managed fund as such, but manager Bill Nygren is mindful of tax considerations in managing his portfolio.

Your own frequent trading can also be costly from a tax perspective. That's because capital gains from investments held for less than 12 months are taxed at an investors' highest marginal tax bracket, not at the 15% rate for those owned for more than a year. Not only is taking a long-term view a wise investment strategy, it's smart from a tax perspective as well.

Search for Bargains
While it might be harder to find attractively priced stocks, they're still out there. Identifying them is no mean feat, of course, but those who can have the opportunity for outsized gains. For many folks, it's easier to stick with investors who have proven records in sniffing out bargains, such as Oakmark's (NASDAQ:OAKMX - News) Bill Nygren, Selected American's (NASDAQ:SLASX - News) Chris Davis and Ken Feinberg, Third Avenue Value's (NASDAQ:TAVFX - News) Marty Whitman, and Bruce Berkowitz and team of Fairholme (NASDAQ:FAIRX - News). Morningstar's stock analysts try to ferret out good values as well. Stocks rated 4 or 5 stars indicate they are trading below what our analysts think they're worth. (Moringstar.com Premium Members can find a list of nearly 1,900 stocks with Morningstar Ratings by clicking here.)

Look for Dividend Growth
Stock returns come from two sources--dividend income and capital appreciation. The latter provided the lion's share of the stock market's outsized gains in the 1980s and 1990s. The runup left stocks with historically high valuations, even after the effects of the brutal 2000 to 2002 bear market are factored in. As a result, stock returns are likely to come not from escalating price multiples, as was the case in the 1980s and 1990s, but from growing dividends.

The good news is that companies are increasing dividends at a healthy clip--S&P 500 companies grew their payouts by around 10% in 2005. Typically, cash-rich blue-chip companies have the greatest wherewithal to boost their dividends. Therefore, it makes added sense to invest in funds that focus on such firms, such as Dreyfus Appreciation (NASDAQ:DGAGX - News) and T. Rowe Price Blue Chip Growth (NASDAQ:TRBCX - News). Those offerings don't explicitly focus on growing dividends, but there are some appealing ones that do, such as T. Rowe Price Dividend Growth (NASDAQ:PRDGX - News) and Vanguard Dividend Growth (NASDAQ:VDIGX - News), also have added appeal.

Avoid Taking Excessive Risk
If you're unimpressed with the broad market's prospects, you may be tempted to chase hot returns and load up on riskier asset classes. Performance-chasing is a loser's game for most who play it. If you don't believe us, just ask the hoards of investors who bought technology funds in 2000 as the tech bubble was just about to pop. And while there's nothing wrong with giving riskier fare a niche role in a broadly diversified portfolio, too much exposure can torpedo your returns. Investors flocking to emerging-markets funds today may not remember that the typical emerging-markets fund shed more than 40% of its value from May to August 1998. As a reminder of the kind of volatility emerging markets often experience, the average fund in the group has slipped 10% over the past month as the stock market has swooned.

To be sure, we're not saying the market is doomed by any means. Perhaps the stock market's prospects aren't as bleak as some predict. But regardless of whether stocks exceed, meet, or fall short of their historical averages, it still makes sense to keep an eagle eye on costs, limit the tax man's take, and avoid taking on too much risk. If the future turns out better than a lot of folks expect, you'll just end up with more in your pockets.

The article previously appeared June 6, 2006.

Christopher Davis does not own shares in any of the securities mentioned above.