Why The Next Decade Will Foil Financial Plans
by Lance Roberts, RIA
This morning I received a āfinancial planā from an individual wanting me to reviewĀ itĀ with respect to his personal retirement goals. The plan was generated by one of the many āoff the shelfā software packages that takes all the inputs of income, assets, pensions, social security, etc., and then spits out assumptions of future asset values and drawdowns in retirement.
The problem is that the return assumptions were grossly flawed.
In all of these plans, it is assumed individuals will have a rate of return of somewhere between 5-10% annually heading into retirement, and then 4-8% thereafter. The first major flaw in the plan is the ācompoundingā of annual returns over time which never happens. The second, and most important, is the future expectation of returns for individuals over the next 10-20 years.
This second point is what I want to address today.
There are two main reasons why returns over the next decade, or two, are currently being overestimated. The first is a āyou problem,āĀ the second is āmathā.
ItāsĀ A You Problem
Last week, I updated the Dalbar Study article which explains why investors consistently āsuckā at investing.Ā As I detailed in that article, one of the biggest impediments to achieving long-term investment returns is the impact of emotionally driven investment mistakes.
Investor psychologyĀ is helpful in understanding the specific thoughts and actions that lead to poor decision-making. That psychology not only drives theĀ ābuy high/sell lowā syndrome, but also the traps, triggers, and misconceptions that lead to a variety of irrational mistakes that reduce returns over time.
There are 9 distinct behaviors that tend to plague investors based on their personal experiences and unique personalities.
As I stated last week:
āThe biggest of these problems for individuals is the āherding effectā and āloss aversion.ā
These two behaviors tend to function together compounding the issues of investor mistakes over time. As markets are rising, individuals are lead to believe that the current price trend will continue to last for an indefinite period. The longer the rising trend last, the more ingrained the belief becomes until the last of āholdoutsā finally ābuys inā as the financial markets evolve into a āeuphoric state.ā
As the markets decline, there is a slow realization that āthis declineā is something more than a ābuy the dipāopportunity.Ā As losses mount, the anxiety of loss begins to mount until individuals seek to āavert further lossā by selling.
As shown in the chart below, this behavioral trend runs counter-intuitive to the ābuy low/sell highā investment rule.ā
āIn the end, we are just human. Despite the best of our intentions, it is nearly impossible for an individual to be devoid of the emotional biases that inevitably lead to poor investment decision-making over time. This is why all great investors have strict investment disciplines that they follow to reduce the impact of human emotions.
More importantly, despite studies that show that ābuy and hold,ā and āpassive indexingā strategies, do indeed work over very long periods of time; the reality is that few will ever survive the downturns in order to see the benefits.ā
The impact of these emotionally driven mistakes leads to long-term under-performance below thoseĀ āgoal basedā financial projections.
Itās Just MathĀ
āBut Lance, the markets has returned 10% on average over the last century, so I will probably be okay.ā
True. If you can contract āvampirism,ā avoid sunlight, garlic, and crosses, you can live long enough to achieve the āaverage annual rate of returnā seen over the last 116 years.
For the rest of us mere mortals, and why āduration matchingāĀ is so crucially important, we only have between today and retirement to reach our goals. For the majority of us ā that is about 15 years.
And therein lies the problem.
Despite much of the commentary which continues to suggest we are in a long-term secular bull market, the math suggests something substantially different. However, it is important to understandĀ when low future rates of return areĀ discussed, it is not meant that each year will be low but the return for the entire period will be low. The charts below show the 10 and 20-year rolling REAL, inflation-adjusted, returns forĀ the markets as compared to trailing valuations.Ā (Important note: Many advisors/analysts often pen that the market has never had a 10 or 20-year negative return. That is only on a nominal basis and should be disregarded as inflation must be included in the debate.)
There are two important points to take away from the data. First, is that there are several periods throughout history where market returns were not only low, but negative. Secondly, the periods of low returns follow periods of excessive market valuations. āThis time is not different.ā
AsĀ David Leonhardt noted previously:
āThe classic 1934 textbook āSecurity Analysisā ā by Benjamin Graham, a mentor to Warren Buffett, and David Dodd ā urged investors to compare stock prices to earnings over ānot less than five years, preferably seven or ten years.ā Ten years is enough time for the economy to go in and out of recession. Itās enough time for faddish theories about new paradigms to come and go.ā
History shows that valuations above 23x earnings have tended to denote secular bull market peaks. Conversely, valuations at 7x earnings, or less, have tended to denote secular bull market starting points.
This point can be proven simply by looking at the distribution of returns as compared to valuations over time.
From current levels history suggest that returns to investors over the next 10 and 20-years will likely be lower than higher. However, as I said, we can also prove this mathematically as well.
Capital gains from markets are primarily a function of market capitalization, nominal economic growth plus the dividend yield. Using John Hussmanās formula we can mathematically calculate returns over the next 10-year period as follows:
(1+nominal GDP growth)*(normal market cap to GDP ratio / actual market cap to GDP ratio)^(1/10)-1
Therefore, IF we assume that GDP could maintain 4% annualized growth in the future, with no recessions, AND IF current market cap/GDP stays flat at 1.25, AND IF the current dividend yield of roughly 2% remains, we get forward returns of:
(1.04)*(.8/1.25)^(1/10)-1+.02 = 1.5%
But there is a āwhole lotta ifsā in that assumption. More importantly, if we assume that inflation remains stagnant at 2%, as the Fed hopes, this would mean a real rate of return of -0.5%.
In either case, these numbers are well below the majority of financial plan projections which will leave retirees well short of their expected retirement goals.Ā
Conclusion
While theĀ majority of analysis is based on the idea thatĀ individuals shouldĀ ābuy and holdā indexed based portfolios, reality has been far different.
With retirement plans having a finite time span for both accumulation and distribution of assets, the time lost in āgetting back to evenāĀ following a major market correction is the primary consideration.
The chart below picks up on the investor psychology chart first shown above. The chart below illustrates the difference between expectations and reality. The illustration shows the difference between the inflation-adjusted return on a $100,000 investment in the S&P 500 Ā growing at 8% annually as opposed to the impact of gains and losses in market returns over time. The reason the chart begins in 1990 is, despite analysis showing 116-year investment returns, roughly 80% of all investors today began investing. Of that 80%, roughly 80% of those began after 1995. If you donāt believe me, go ask 10 random people when they started investing in the financial markets and you will likely be surprised by what you find.
Unfortunately, most investors remain woefully behind their promised financial plans. Given current valuations, and the ongoing impact of āemotional decision making,ā the outcome is not likely going to improve over the next decade or possibly two.
Markets are not cheap by any measure. If earnings growth continues to wane, interest rates rise, not to mention the impact of demographic trends, the bull market thesis will collapse as āexpectationsā collide with āreality.ā This is not a dire prediction of doom and gloom, nor is it a ābearishā forecast.Ā It is just a function of howĀ the āmath works over time.ā
For investors, understanding potential returns from any given valuation point is crucial when considering putting their āsavingsā at risk. Risk is an important concept as it is a function of ālossā. The more risk that is taken within a portfolio, the greater the destruction of capital will be when reversions occur.
This time is ānot different.ā The only difference will be what triggers the next valuation reversion when it occurs. If the last two bear markets havenāt taught you this by now, I am not sure what will.Ā Maybe the third time will be theĀ ācharm.ā
Lance Roberts
Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of āThe Lance Roberts Showā and Chief Editor of the āReal Investment Adviceā website and author of āReal Investment Dailyā blog and āReal Investment Reportā. Follow Lance on Facebook, Twitter, and Linked-In