Vanguard, the second largest asset manager inthe U.S., expects higher risks and lower returns in financialmarkets next year.

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“We anticipate a bit more volatility and an uptick in inflationin the year ahead, accompanied by more muted equity returns,” saidJoseph Davis, Vanguard’s chief economist and investment strategygroup head, in a statement accompanying the firm’s 2018 market outlook.

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In what it termed its “most subdued” market outlook in a decade,Vanguard forecast a 3% to 5% return in U.S.equities — down sharply from the 10% annualized rate over thepast 30 years — and a 5.5% to 7.5% gain in foreign equities.Fixed income assets are expected to return 2% to 3%.

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Related: 10 trends from the Vanguarduniverse

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Moreover, Vanguard sees more downside risks in equities than inthe bonds despite the expectations for higher inflation and greaterodds of a market correction in the U.S. rather than overseas.

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Take a look at this chart:

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U.S. equities are approaching historical highs in valuation butnot grossly overvalued, while non-U.S. developed markets are fairlyvalued and emerging markets are slightly overvalued, according toVanguard.

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“The sky is not falling but our market outlook has dimmed,”notes the outlook.

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And the risk of higher-than-expected global inflation hasincreased, according to Vanguard. It expects the U.S. FederalReserve will likely raise rates to 2% by the end of 2018 — orthree more times after an expected December 2017 hike — whilethe ECB delays rate hikes for another two years.

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Vanguard cautions investors against reaching for a “shiny” newinvestment strategy such as oveweighting emerging market equitiesand high-yield corporate bonds. Those strategies will not gain asmuch as they have in previous decades, according to Vanguard.

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The mutual fund giant advises that investors diversify assetsglobally, maintain disciplined asset allocation with periodicportfolio rebalancing, use low-cost strategies and keep in mindrealistic return expectations.

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Bernice Napach

Bernice Napach is a senior writer at ThinkAdvisor covering financial markets and asset managers, robo-advisors, college planning and retirement issues. She has worked at Yahoo Finance, Bloomberg TV, CNBC, Reuters, Investor's Business Daily and The Bond Buyer and has written articles for The New York Times, TheStreet.com, The Star-Ledger, The Record, Variety and Worth magazine. Bernice has a Bachelor of Science in Social Welfare from SUNY at Stony Brook.