Meb Faber Tweeted out portfolio return expectations from various market participants looking out over the next ten years. Vanguard was at the low end looking for 4.5%, the “average investor” was in the middle at 10.2% and hedge funds think they will generate 13.0%. Depending on who you read you can find expectations in the three’s as well.

John Hussman tends to look at this by factoring in current valuations and based on those valuations, figuring what the return probability “should be.” Jeremy Grantham looks at a multitude of inputs to make similar, long-range forecasts. You have no doubt heard/read the concept of borrowing from future returns when getting high current returns. Have the last nine years borrowed or taken in some part, what investors might hope for over the next nine years or some other period. The answer isn’t knowable, but it is an appropriate question.

It is also appropriate to have something in mind if the next ten years return less than half of the previous ten years, at least where the S&P 500 is concerned. Fortunately, we have something of a blueprint in the ten-year period ending February 2010 where Google Finance shows a decline of just over 20% on a price basis (so probably about flat with dividends), obviously far worse than the 4.5% Vanguard is looking for.

In that run, foreign and emerging equities outperformed domestic by a wide margin, as did commodities thanks to a potentially unrepeatable super cycle induced by Chinese demand. Between foreign and domestic equities, one must outperform the other in a given time period and the historical tendency has been for one to outperform the other for many years at a time. Domestic was the leader this decade until last year, foreign outperformed domestic for the previous decade and domestic outperformed for most of the 80’s and 90’s.

Commodities are trickier and while I would want any allocation to be much smaller to them than any sort of equity exposure someone worried that a Vanguard scenario or worse is coming would be well advised to spend time looking for an opportunity in that space.

I write frequently about alternatives and there will be segments in that realm with the potential to deliver something close to that 4.5% with much less volatility, again for anyone thinking Vanguard is on to something with low expectations.

Perhaps an even more important piece of understanding is that even if Vanguard is right, the returns won’t be linear. In any random ten-year period, there will be at least a couple of very good years, two or three mediocre years and a couple of terrible years.  The years in that last sentence add up to six or seven years, those remaining three or four will determine whether the hedge funds Meb was talking about are correct or Vanguard is or whether some outcome turns out to be the answer.

In a ten-year period that averaged 4.5% with two years in there that goes up a lot, the damage done by missing one of those two strong years due to some irrational thought like “I don’t like the market” would be very bad. Think about it, if the average of 4.5% includes one year of up 20% and that is missed, then that investor’s average will drop a couple of hundred basis points.

On the flip side, missing the full brunt of one of those bad years could help lift that average. This scenario is exactly what happened in the ten-year period ending February 2010. An investor not absorbing the full brunt of 2008 saw their average return for what was a lousy decade, improve versus their likely benchmark (assumes the S&P 500). I probably have written over 1000 posts on my thoughts on how to avoid the full brunt of a bear market, and while there are quite a few indicators that warn a bear is more likely, my preferences remain the S&P 500 breaching its 200 day moving average (especially if the slope of the DMA is negative), an inversion of the yield curve (it isn’t inverted until it is actually inverted) and the 2% rule (the market averages a 2% decline three months in a row).

Don’t spend time guessing what the average return will be for the next ten years, instead game plan for a market that turns out to offer disappointing returns.