Recently, I ran across a heated debate in an online discussion group about the returns used in various projections provided to clients. The debate started with one poster concerned about future returns. In particular, he worried that the Monte Carlo Simulation engine in his software was using the long-term historical returns for U.S. Treasuries as the proxy for bonds. He pointed out that with yields so low, illustrating a return near 5%, had to be unrealistic.
His solution was to change the default in his software to use the current yield on the 10-year U.S. Treasury as the mean. Other posters suggested that it was easier to just knock off a percent or two from the portfolio return parameters across the board.
Another poster quickly pointed out that the characterization of “unrealistic” had some embedded assumptions in it. Illustrating the viability of a retirement usually means a multi-decade time frame. Is it fair to assume that today’s rates will persist that long?
This triggered discussion about future equity return expectations. Valuations are above the historic average suggesting lower than average returns going forward. Will that actually happen? Valuations have been above average for years. Maybe something is different now. Even if that is not the case, will valuations remain high for the next few decades?
Then the debate shifted from how to alter the parameters to should planners alter the parameters from using historical data to using something else. It’s a worthy conversation.
One thing the historical record has going for it is it describes real life. The returns are not theoretical, they actually happened. The stock market crashed in 1929 and financial markets during the Great Depression were extremely volatile. Inflation was very high through the 70s. Corrections occurred every other year, on average. Almost every president has been in office when a “bear market” 20% decline in stock prices hit.
Yet the good ‘ole “4% rule” never failed. There should be some comfort in that for clients and their planners.
However, that record is far from a guarantee of future results. Just because something has always worked doesn’t mean it always will and just because something has never happened doesn’t mean it can’t. Plus there are aspects of the historic record that are less than comforting.
The 4% statistic is a U.S. phenomenon. Isolating other countries generally yield poorer results (Phau). There have been periods in which yields were low and there have been periods where equity valuations have been high but before the last few years, there had not been a time when yields were near historic lows and valuations near historic highs.
This nagging truth begs an exploration of what could happen.
Bond yields are highly correlated to future returns. In fact, if you select a specific maturity from a sound issuer, there is little doubt what the return will be. Between now and 2025, you don’t know what the bond will be worth on any future date but if you buy a five year Treasury today, in 5 years you’ll get exactly what you signed up for, roughly 1.63% as of this writing.
Equity returns are tougher. There aren’t any great predictors of future returns. The one valuation measure that has received the most attention for its predictive value is Shiller’s P/E 10 ratio. What is often lost in its mentions is the fact that while P/E 10 has more explanatory power than other valuation measures, the P/E 10 is not a great predictor.
A Vanguard study, “Forecasting stock returns: What signals matter, and what do they say now?” found that P/E ratios only explained about 40% of future returns from 1926-2011. P/E10 had an R-squared of .43 to subsequent 10-year returns, a slight improvement from using the one year P/E which had an R-squared of .38
If you are looking at valuation levels to move in or out of markets, you are likely to be disappointed. The best predictor of 1-year returns had an R-squared of a mere .12. As the study pointed out, “…stock returns are essentially unpredictable at short horizons… Quite frankly, this lack of predictability is not surprising given the poor track record of market-timing and related tactical asset allocation strategies.”
This also means that clients who read about high valuations and turn those statistics into an anxiety-riddled fear of a crash are likely working themselves up for no reason. A good financial planner may be able to bring some perspective to the table. The Vanguard study I cited was written in 2012. Valuations were high and yields were low then yet returns have been good for equity investors and more than adequate for reasonably constructed balanced portfolios.
The result of the last decade or so is another example corroborating the primary conclusion the authors of the Vanguard study make, “…expected stock returns are best stated in a probabilistic framework, not as a ‘point forecast,’” and should not be forecast over short horizons.
That gets us back to Monte Carlo Simulations. If we are going to use estimates of future returns that are less favorable than the historic record, what do we use? The most popular method on the board was to simply reduce the mean by a couple of percent or so. This method was likely the top choice because it was a choice that could be made given the software’s limitation.
I have read a few studies that use different approaches. In one (Blanchett), low yields were used for the first part of simulated retirements to reflect today’s low yield environment. Instead of assuming that would persist, latter portions of the retirement horizons used yields more in line with historic yield levels.
But these are issues of how. The question that sparked the online debate was, “Should we use historic returns or our estimates of future returns when running a simulation?” Maybe we should do both. Run one with history-based parameters and one with a reasonably thought out good faith estimate. The whole point of MCS is to show a range of outcomes, not serve as some sort of crystal ball.
One knock on using historic returns is it can give clients a false sense of security. Well, regardless of whether you use one of the methods I just mentioned or some other approach that uses below historic average returns, the simulations will show more failures. This can lead clients into a false sense of dread. Use both and clients may get the idea that the future is full of uncertainty. That’s a good thing for them to believe because it’s true.
MCS results only offer the odds of failure if the assumption that the client makes no adjustments to what is modeled holds true. The assumption that people will just keep going along in the face of a growling bear is dubious. Instead, present MCS results as offering the odds that clients should do something different than what is illustrated.
You can then lead them to the discussion that can make the most impact on their lives, identifying what these different actions are. This focuses them on what they can and cannot control. Markets are uncontrollable but their behavior is not. They have choices that can improve outcomes. What are the behaviors that can make them successful?
When portfolios don’t grow or shrink, clients might choose to work longer, save more or, if already retired, spend a little less. The studies on sustainable portfolio withdrawals show that such adjustments can be powerful. Altering an asset allocation is not likely to be a big help, at least from what my business partner, Mike Salmon, and I can tell from our recent study (Journal of Financial Planning Jan 2020).
The asset allocation alteration that can have a big impact is panicking and selling after a large decline. Clients can reduce the risk of this behavior by recognizing that one thing they can control is their intake of news. How do they ingest information and how do they react to it? If they admit watching cable news gets them wound up, they may be able to choose to get their information elsewhere or work on changing their reaction to what they ingest.
Instead of filling them with anxiety over the unpredictability of financial markets, talking with them about what they can and should do when the inevitable volatility arises may better prepare them. I heard football coach Lou Holtz once say, “Pressure is what you feel when you are not prepared.” Financial planning is about preparation, not prognostication.
Dan Moisand, CFP, has been featured as one of America’s top independent financial advisors by Financial Advisor, Financial Planning, Investment Advisor, Investment News, Journal of Financial Planning, Accounting Today, Research, Wealth Manager, and Worth magazines. He practices in Melbourne, Fla. You can reach him at [email protected].