Three times in the last 10 days, I have been exposed to a rather heated debate about the expectations for returns for stocks and bonds. Each person presented their case with great passion and enthusiasm.
With such a large amount of time and energy put into the issue, it would be easy to assume that having the right answer to the question of “what will the markets do?" is critical to successful financial planning.
It ain’t.
Life presents too many variables and too much chaos. The critical issue is not so much one of “What if?" It is a matter of “What then?”
I guess some people get lured into trying to find the “correct” forecast of the equity risk premium because it sounds more sensible than predictions of the next crisis or market correction. The latter predictions feel more speculative and unlikely to work over the long term.
I put the word “correct” in quotes because the word seems to be defined differently by various creators of the forecasts.
Some describe their estimate as a destiny. “X% is what you will get.” Hopefully you don’t take that suggestion too seriously.
Some describe their estimate as a ceiling. “X% is the most you will get.” This is only marginally better than the destiny approach.
Most describe their estimate as a probability. “X% is what you will probably get.” The more realistic they are about the range of possibilities around their expectation the more credible they strike me.
It is notable that the methods used to come up with these prognostications vary considerably. What I see most often are building block methods and valuation based methods.
A building block method would be something like dividends + earnings growth + inflation + multiple expansion = expected return. The size of these components and whether they are actually negatives rather than pluses varies from one prognosticator to another.
For valuation, you’ll see things like “At this P/E, the market has averaged X% over the next 10 years.” Often the presenter will substitute price to book, or sales, or use a trailing P/E, CAPE ratio, or similar.
These forecasts are not useless but they can be misused. Bad behavior can trump a lot of good thinking.
I write a couple of Q&A columns for consumer media and can say with confidence that there are two common reactions of the general investing public to a return forecast.
The first is to view the forecast as a matter of destiny or as a ceiling. This is often interpreted as low equity premiums mean one should own less stocks. It is rare that people realize that if the premium is lower, all things being equal, to get the same result, one actually needs more stocks.
The second reaction of the public is to translate an above average valuation into a prediction of an imminent market crash. Studies of the matter are clear. The better predictors of future returns are P/E related and are most effective predicting the next 10 years.
However, “better” and “most effective” is misleading. They really aren’t great predictors even over ten year periods. The range of results for any given valuation level is still quite wide. Certainly not a matter of destiny.
For shorter periods like the next 12 months, there simply is no valuation measure that is a good timing indicator. CAPE ratios, P/E, GDP growth, dividend payouts, government debt levels, the Fed model and other data points all have little to no predictive value.
Most real financial planners are not hot on trying to time the market but many are struggling with what to do with the strong consensus that the expected returns and the probable variation around those expectations has made an adverse shift.
Part of the issue for planners is that it isn’t just a matter of low equity returns. Interest rates are darn low, making future returns from the fixed income portion of a portfolio less productive.
It helps somewhat that fixed income returns are rather predictable. Barring default it is basically mathematics. If everything is paid on time, yield to maturity is what you will get between now and maturity.
What I see and hear often of late is planners changing the inputs of planning software to reflect equity returns below that of the historic record and today’s lower interest rates. Not surprisingly, the results of simulations indicate lower probabilities of success. I lost count a longtime ago of papers pinning the safe withdrawal rate under 4% or otherwise declaring the 4% rule a relic or pipe dream.
I have concerns with this approach, particularly when it assumes the range of results will be skewed lower for the entire lifetime of the family whose retirement is simulated. The trend is to call the historic record too optimistic. Fine. But extrapolating today’s condition into the next 30 years or more strikes me as overly pessimistic.
Successful financial planning is bringing realism to a clients’ thinking but it is also about putting families in position to maximize the odds they can get what they want out of their life. If we are overly optimistic, we underestimate the probability and severity of a mid-course correction. If we are too conservative with our assumptions, don’t we improve the odds clients won’t run out of money?
Of course. However, the flip side of that is that being overly pessimistic is likely to mean telling people to work longer than they need to or skip doing things early in their retirement that are meaningful to them.
Congratulations. You kept the clients from one thing they did not want. You also kept them from the life they did want and that they worked their whole life to experience.
This can happen when the focus is on getting a “good” forecast into a bad model.
A model that assumes a stable inflation adjusted spending pattern regardless of what is happening in the world is simply not realistic. People do not behave that way.
On one hand behavior change adds to the uncertainty but on the other it is precisely why clients can have successful outcomes despite all the uncertainty.
Don’t just ask the software “What if the market returns are weak?” It will give you an ugly answer that you or your clients may interpret as a reason to forego the life they want. It may not have to be that way.
Clients will be much better off asking “If markets are weak, what will that look like, when should we do something, and what will we do then?”, “If they are average what will that look like and what will we do then?”, and “if they are strong, what will that look like and what will we do then?”
Life is not a “set it and forget it” proposition. Neither is financial planning. Preparing is better than predicting. Software and academic studies are just tools to be used to make sure our preparations have some basis in reality.
Dan Moisand, CFP, has been featured as one of America’s top independent financial advisors by Financial Planning, Financial Advisor, Investment Advisor, Investment News, Journal of Financial Planning, Accounting Today, Research, Wealth Manager, and Worth magazines. He practices in Melbourne, FL. You can reach him at [email protected]