Stop Fooling Yourself About 8% Easy Returns

Many tell McKnight they need 8% returns a year; he'll tell them about 7% is more possible over the next five to 10 years and only with more aggressive allocations to equities and emerging markets. About 5% is more likely. They'll often stick with their outlooks anyway.

Here's the problem: The only way to meet these lofty returns goals is to take much bigger risks than in the past, and to do so at a time when many are already accepting relatively little compensation for bigger gambles. For example, the earnings yield on the S&P 500 is just 4.6%, compared with nearly 6% over the past decade historically, while junk-bond yields are 5.6% compared with 8.3% historically.

So far, many analysts say the market isn't prone to a collapse because of a lack of leverage in financial markets. It's true that valuations are high. And many companies have been increasing their debt relative to income. But this isn't generally the type of leverage that will automatically sink markets in a fast, broad-based manner.

That said, if investors cling to these inflated visions of future returns, problems will ensue. Unless people save more money and ratchet back their expectations, they'll likely end up seeking classic methods to juice gains — namely, investing in funds that borrow short-term money to invest in longer-term assets.

It's important that investors are realistic. If they're not, fund managers will try to serve their hopes and dreams, making the financial system all the more fragile for it.

— Read 5 Ways Washington Is Choking Your Annuity Business on ThinkAdvisor.