One of the foundations of meeting an investment/savings goal is understanding the rate of return you expect to earn on your investments. For instance, given a rate of return, you can answer questions like ...
Given the fundamental importance of an expected rate of return on your investments, a deeper understanding of the nature of future returns is necessary. There are three main points that I try to convey when talking or writing about Expected (or future) returns in the main Asset Classes of Stocks, Bonds, and Cash.
The first point I try to get across is that higher returning asset classes generally have more variation in returns - they are more volatile - in the short run (If you are interested in a comparison of horizon downside risk versus annual drawdown risk read this piece). In the short run, higher risk asset classes have a higher probability of loss and a greater downside when a loss is realized. For example, the following is a chart of one measure of downside risk for the three main asset classes of Stocks, Bonds, and Cash. To proxy the three asset classes, I am showing using the SPY etf to proxy the stock market, I am using the AGG etf to proxy the bond market, and I am using a Treasury Bill ETF to proxy cash. Furthermore, good returns and bad returns tend to clump. Most extreme downside risk periods happen during recessions.
The second point that I try to get across is the old adage in the investment markets that past performance is not an indication of future results. While past performance can definitely be used as a guide to understanding the components of stock market returns, naively using past performance as a proxy for future expected returns is misleading at best and outright malpractice at its worst. There is a great amount of variation in the return patterns for Stocks, Bonds, and Cash. If we only look at the 10 year average rolling returns for the S&P 500, the 10 year Treasury and Cash, you can see that the 10 year average return has ranged from x to x for stocks, y to y for the 10 year Treasury Note, and z to z for cash. Understanding whether we are about to enter into a "good" period for returns or a "bad" period for returns is very helpful in designing investment solutions to meet various financial goals.
The third point that I try to get clients to understand is that current valuations drive most of the longer term variation in returns. Relatively higher valuations, based on metrics I will get to shortly, lead to relatively lower future returns on longer term (10 years and longer) time horizons. Furthermore, most year to year variation in asset class returns is driven not by what I call the underlying yield of an asset class, but rather by an asset class deviating away from longer term fair value levels. In particular, for Stocks we will use Shiller's CAPE10 metric as a valuation metric and we will use the 10 Year real yield as a valuation metric for the 10 Year Treasury. Just look at how much of the volatility is driven by the change in valuation versus the change in underlying yield.
So what does this all mean for investors today? I should caution any readers that they should seek the counsel of a financial advisor before making any investments or changes in their investment portfolio based on the following... Given current levels in Shiller's CAPE10, U.S Large Cap stocks have a very low 10 Year expected return compared to past historical periods. Valuations are higher than any period except for the NASDAQ bubble, therefore 10 Year expected returns are lower today than any time except for the period at the end of 1999 and 2000. In addition, with the yield on the 10 year treasury at very low levels, the 10 year expected return for the bond market is also very low. A combined portfolio of 60 % stocks and 40% Bonds has the lowest expected return of any portfolio since the end of World War II.
Practically, given low expected returns for the next 10 years, one would expect that ...
- If I save 10% of my income, how many years do I need to save before I can buy a 30 year annuity that replaces 80% of my income?
- What percentage of my income do I need to save to be able to retire at age 60 and be able to buy an annuity that replaces 80% of my income?
- How much of my current income can I replace with an annuity if I save 15% of my income for 20 years?
Given the fundamental importance of an expected rate of return on your investments, a deeper understanding of the nature of future returns is necessary. There are three main points that I try to convey when talking or writing about Expected (or future) returns in the main Asset Classes of Stocks, Bonds, and Cash.
The first point I try to get across is that higher returning asset classes generally have more variation in returns - they are more volatile - in the short run (If you are interested in a comparison of horizon downside risk versus annual drawdown risk read this piece). In the short run, higher risk asset classes have a higher probability of loss and a greater downside when a loss is realized. For example, the following is a chart of one measure of downside risk for the three main asset classes of Stocks, Bonds, and Cash. To proxy the three asset classes, I am showing using the SPY etf to proxy the stock market, I am using the AGG etf to proxy the bond market, and I am using a Treasury Bill ETF to proxy cash. Furthermore, good returns and bad returns tend to clump. Most extreme downside risk periods happen during recessions.
The second point that I try to get across is the old adage in the investment markets that past performance is not an indication of future results. While past performance can definitely be used as a guide to understanding the components of stock market returns, naively using past performance as a proxy for future expected returns is misleading at best and outright malpractice at its worst. There is a great amount of variation in the return patterns for Stocks, Bonds, and Cash. If we only look at the 10 year average rolling returns for the S&P 500, the 10 year Treasury and Cash, you can see that the 10 year average return has ranged from x to x for stocks, y to y for the 10 year Treasury Note, and z to z for cash. Understanding whether we are about to enter into a "good" period for returns or a "bad" period for returns is very helpful in designing investment solutions to meet various financial goals.
The third point that I try to get clients to understand is that current valuations drive most of the longer term variation in returns. Relatively higher valuations, based on metrics I will get to shortly, lead to relatively lower future returns on longer term (10 years and longer) time horizons. Furthermore, most year to year variation in asset class returns is driven not by what I call the underlying yield of an asset class, but rather by an asset class deviating away from longer term fair value levels. In particular, for Stocks we will use Shiller's CAPE10 metric as a valuation metric and we will use the 10 Year real yield as a valuation metric for the 10 Year Treasury. Just look at how much of the volatility is driven by the change in valuation versus the change in underlying yield.
So what does this all mean for investors today? I should caution any readers that they should seek the counsel of a financial advisor before making any investments or changes in their investment portfolio based on the following... Given current levels in Shiller's CAPE10, U.S Large Cap stocks have a very low 10 Year expected return compared to past historical periods. Valuations are higher than any period except for the NASDAQ bubble, therefore 10 Year expected returns are lower today than any time except for the period at the end of 1999 and 2000. In addition, with the yield on the 10 year treasury at very low levels, the 10 year expected return for the bond market is also very low. A combined portfolio of 60 % stocks and 40% Bonds has the lowest expected return of any portfolio since the end of World War II.
Practically, given low expected returns for the next 10 years, one would expect that ...
- One would save a little bit more to retire with the same nest egg versus other periods in history.
- Given a constant savings rate, one would work a little bit longer to retire with the same nest egg versus other periods in history.
- One would expect to have a little bit less to spend in retirement versus other periods in history.
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