We in the investment management business have gotten complacent, perhaps even lazy. It's not our fault, really, we just don't know any better. The vast majority of financial advisors entered this industry post 1981; the only trend these advisors know is consistently declining interest rates and rising equity prices, leading them to asset allocate, preach patience and advise clients to hold long term. This is certainly a strategy that has worked for the better part of three decades, but will it work going forward?
Traditional asset allocation is dead. Advisors that adapt to this new climate will survive--those that don't will go the way of the dinosaur.
The United States has enjoyed the enviable position of having the world's reserve currency since the signing of the Bretton Woods Agreement in 1944. Because of this, the U.S. has been able to sustain an almost unimaginable rate of public and private growth for over 60 years. All dollar-denominated assets have risen in price and, almost amazingly, interest rates have declined to near zero. The last 28 years alone have seen long-term U.S. interest rates fall from near 20% to 4%! Equities, we're often told, have a historical return of about 10% annualized. Buy and hold, both stocks and bonds, and you'll be rewarded handsomely in the long run.
However, taking today's economy into consideration, any astute observer will note that the dollar's days as global reserve currency are coming to an end and with it, all of the trends upon which we've come to rely for our financial planning.
The only conceivable option for managing our $12 trillion of public debt as well as the $60 trillion to $80 trillion of unfunded future liabilities is to devalue our currency by the issuance of new money. In economic terms, you pay off yesterday's liabilities with the cheaper currency of tomorrow. By doing this, our debased currency will ultimately lose its validity on the world stage. Market forces will propel interest rates higher, regardless of the actions of the Federal Reserve. The 28-year bull market in fixed-income securities will end and with it, the effectiveness of traditional fixed income as an asset class and a "safe haven" investment. Declines in bond values will outpace coupon yields making fixed income an asset class with negative total returns for the foreseeable future.
How about U.S. equities? I would challenge the very notion that the long-term return in stocks is 10%. Almost all of the positive return in the stock market over the past 110 years has come from four "super decades." Equity returns outside of these decades are close to zero. The decades are:
1920-1929: Average return 11.77%
Reason: Post-WW1, the U.S. had the world's only healthy manufacturing base and was an emerging world power.
1950-1959: Average return 15.98%
Reason: Post-WW2, the U.S. again had the world's only healthy manufacturing base. The U.S. dollar became the world reserve currency as the decade began.
1980-1989: Average return 15.62%
Reason: Historic decreases in interest rates coupled with record levels of fiscal stimulus and tax cuts.
1990-1999: Average return 18.37%
Reason: U.S. won the Cold War, emerging as sole economic superpower. Interest rates remained historically low.
Outside of these four decades, the average annual return in U.S. equities is just 3.31% and this includes dividends. So, unless you expect the U.S. to emerge victorious in some sort of cataclysmic new war, you may want to permanently reduce your exposure to U.S. stocks. If you don't believe that a new era of prosperity, based upon lower taxes and even lower interest rates, is just over the horizon, you would be well advised to adjust your client's asset allocation.
The traditional asset allocation models have served us well. A balanced portfolio of 70% equities invested primarily in the United States and 30% fixed income has proven, over time, to minimize risk while maximizing return. However, times have changed. We are sailing toward the New World without a compass or even a sextant. Industry literature clearly states that "past performance is no predictor of future results." Today's financial advisors would be wise to heed that warning.
Craig Hemke is a 20-year securities and insurance industry veteran. In 2008, he founded BuyaPension.com, an online sales site for individuals looking to research and purchase single premium immediate annuities.