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(Bloomberg Gadfly) — There’s an amazing amount of denial going on right now.

Investors are simply ignoring current market dynamics and are still expecting average annual returns of 8.6%, according to a Legg Mason Inc. survey of income investors released this week. Those who were employed expected more than 9% gains, with retirees expecting less. Actual returns have come in markedly lower of late, but hopes remain high.

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This is wishful thinking at best and dangerous at worst. Today’s stock and bond markets are profoundly different from those in decades past. Bond yields are near all-time lows. Stocks aren’t paying that much relative to history in terms of earnings yield. Yes, prices could continue to rise, but that’s becoming less certain as central bankers seek to tighten monetary policies and valuations get increasingly squeezed.

This new dynamic is no secret to anyone who manages money professionally. It’s alarming that the hundreds of investors surveyed by Legg Mason still have such unrealistic expectations. Alan McKnight, chief investment officer at Regions Wealth Management, said he had seen similarly over-optimistic expectations from nonprofessional investors he’s spoken with. “People want to look on a historical basis as to what they should expect in the future,” he said Friday on Bloomberg Radio.

A More Likely Outcome: 5%

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.

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