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If only all of us had the assumed power of hindsight that Will Rogers speaks to; we would never have to worry about issues such as stock, bond, real estate or fund asset allocation choices. We would not care what our real rates of return have been (and more importantly, will be) on our investments after all costs.
Unfortunately, we live in the real world, where many assumptions that were taken as gospel in the investment community are being brought into question.
One such assumption is that equities will deliver the majority of your portfolio’s return.
For example, the Ibbotson Graph below shows how much better stocks (both small cap and large cap) have outperformed bonds and inflation over the last 80 years or so.
However, if we change the time frame, we can see that since 1981 bonds have beaten stocks – and with a lot less volatility.
As in Aesop’s great fable “The Tortoise and The Hare,” bonds eked out a close victory over the “equity hares.” Of course, it helps when you start a bull market with bond yields approaching 18% and end with them at 2%. Obviously we will not see this story re-enacted anytime soon.
While many books tout the efficacy of stocks as part of one’s portfolio (“Stocks for the Long Run” by Jeremy Siegel is but one), for some, right now 30 years is a lifetime, not a “long run,” and that is certainly a long time to watch stocks perform the same, on aggregate, as bonds.
Another long-term investment assumption that is under threat is that a balanced portfolio should make a “real return” of 4%/yr. – a net return after inflation and ideally after fees.
So this raises at least a couple of questions:
- Are these assumptions still reasonable?
- What impact would it have on your investment strategy and savings requirements if you lowered your real rate of return assumption to 3% or even 2%?
- What happens if you allocate a smaller part of your wealth to stocks? How will that affect the likelihood of you reaching your overall investment objectives?
- Is the past any guide to the future?
- Besides stocks and bonds how have other asset classes such as gold, real estate, and alternative strategies performed in relation to inflation?
As we have written about in the past, there can be no doubt that there are issues with traditional investment approaches. But before we look at these questions in more detail, it is our belief that one can greatly mitigate the effects of long periods of sub-par investment return environments with a combination of good planning and balanced asset allocation. The proof is below.
Mark Twain once wrote: “Never let the facts get in the way of a good story.”
So even though we are going to give you the facts, we’ll do our best not to ruin the story.
Before we look at the hard data let’s consider how one factor such as real inflation-adjusted return can wreak havoc on one’s retirement plans.
Robert Browning and his wife Elizabeth own a successful book publishing company (of course they do). They are both 40 and recently came in to see us with their financial information. Amongst the analyses that were done, one spreadsheet looked at how much they might reasonably need to save each year in order to retire by age 60 on their stated goal of $150,000/yr. after tax in 2012 dollars (“$2012”).
At a real return of 4% annually, the required savings were a very manageable $50,000/yr. (Keep in mind many other factors affect what their annual savings requirements will be, including tax rates, funds needed for education of children, size of estate one wants to leave, etc.).
However, what happens if we change that return assumption to 3% or even 2%? The chart below shows the outcomes, and they are not pretty. Robert and Elizabeth would have to more than double their savings if long-term returns drop by only 1% and almost quadruple them if they fell to 2% annually.
This raises a lot of questions for the Brownings:
- Should they change their savings goal to accommodate a more conservative assumption of future returns?
- Should they consider changing their retirement goals (when to retire or on what level of income)?
- Should they become more aggressive in their asset allocation to try and achieve higher real rates of return?
- Should they hope they can learn to write great poetry and make millions?
Notwithstanding Twain’s good advice, we are going to let some facts get in the way of this good story (it’s a mystery, but don’t worry, it all turns out well in the end).
Recently, Barron’s provided the following data about how stocks have performed by decade since the 1930’s.
Using these numbers as a starting point, let’s make some adjustments to also factor in inflation and fees by decade. The chart below shows the return of the S&P 500 including dividends, after fees (1%) and inflation.
The straight line indicates that the average S&P 500 return (including dividends, after fees and inflation) has been 5.3% since 1930. So what can we observe from this data? The glass is both half full and half empty.
On the plus side:
- Over 80 years we indeed achieved a real return comfortably over our desired 4%.
- We did not pick a bull market to start with since January 1930 was still very close to the peak of the prior bull market of the 1920’s.
- This is obviously not a balanced portfolio. From the Ibbotson chart we know that the real return on corporate bonds for the last 80 years after fees would have been just over 2%/yr. Assuming the traditional 60% stock and 40% bond portfolio the net return of a balanced portfolio would have been 4.5%/yr. That would support the notion that a balanced portfolio of high quality stocks and bonds will support a 4% real return assumption.
Looking at the negatives:
- Over half of that time, real returns were well below 4%/yr. (1930s, 1940s, 1970s and the 2000s). The average of these 40 years is -0.75%/yr.
- The 2000s were by far the worst decade and a full 6%/yr. worse than the 1930s on an inflation-adjusted basis.
- Even though the 80-year history shows that real returns of 4% are possible, today we are starting with zero short-term interest rates and 2% 10-year government bond rates. Structural deficit issues all over the developed world along with demographic liabilities do not instill
confidence that we will duplicate the returns of the past.
What about the 80-year performance of other asset classes?
It is quite hard to find data going back 80 years or so. In areas such as real estate there is anecdotal evidence of commercial and multi-family returns over that period, but the major source of hard real estate data is NAREIT (North American REITs). The chart below gives us some indicators for other asset classes.
And what about investments such as mortgages and private equity that do not have anything close to 80-year horizons? Can we make any assumptions about their future performance?
We feel that first mortgages have similar risk and slightly better returns than one would expect from investment-grade corporate bonds, while second mortgages on income-producing real estate assets have risks one might associate with high yield bonds, but with perhaps less volatility.
In both cases, mortgages have less liquidity than their bond brethren, but are, in the end, good risk-adjusted ways to increase yield on the fixed income component of your portfolio.
Private equity is relatively new, and while historical returns do show a significant improvement over large cap stocks, we only have records going back perhaps 20-25 years. Going forward it might be reasonable to assume that, given the risk and nature of capital markets, the overall PE (Price-Earnings ratio) might show the same returns as small cap stocks.
In our opinion this is an area where asset managers can add value.
Back to the Brownings
Now that we have so rudely interrupted our story with a plethora of facts, what advice should we give the Brownings?
Do they continue to assume they will earn a 4% real rate of return even if that has not been the case for the last 5 years or so? Their investment lifetime could be another 50-60 years – is that long enough for the averages to work out?
What better way to answer these questions than with more data?
As many of our clients know, we focus on cash flow as being an important part of returns for their portfolios. Two of the asset classes above (large cap stocks and real estate) have been able to achieve that 4% real return over an extended period of time. In addition, a significant portion of their returns have come in the form of rents and dividends.
- While the current yield on the S&P 500 is only 2.2%, it has averaged 4.2% for the last 80 years. And with dividends reinvested, it represents more than 50% of the total return from this asset class.
- Right now, U.S. companies are paying a record low 28% of their profits in dividends (likely because of misguided attempts to prop up their stock price and stock options with share buybacks). If they reverted to the long-term distribution of 40% of net income (which would leave plenty for future growth), the current yield would be about 3.2% – or 50% more than 10-year government bonds. With aging boomers we can expect to see dividend-payers increase, since it is also one of the best ways to sustain price.
- NAREIT reports that since 1971, equity-based REITs have earned a total return of 11.4%/yr. and have paid an average yield of 7.1%. If you invested $100 in 1971, today, with the index alone, you would now have $425. On the other hand, if you reinvested all of your dividends your investment would now be worth about $9,600 – or almost 20 times the value of the index today without the cash flow.
Before we get back to recommendations for the Brownings, JP Morgan published this asset allocation for their HNW clients (more than $25-million of assets) in Barron’s recently.
For cash flow and diversification reasons, we would switch the single strategy hedge fund allocation with the real estate (18% vs. 3%). However we do agree on overall equity exposure at about 30%.
So where does that leave the Brownings?
- Even though they have not experienced a 4% real return over the last 4-5 years, we believe they will over their investment lifetime if they focus on the asset classes noted above.
- Right now they are buyers of assets and will be for a minimum of twenty years. Having those asset prices fall or rise slower than they have traditionally will in fact improve their long-term returns. But to make that work, they must save regularly and now reinvest all income they earn on their assets back into their portfolio and acquire more assets. (This is basically a form of “dollar-cost averaging,” where we use the cheaper price of the asset today to offset the more expensive price paid earlier – all with the belief that the value will continue to increase over time.)
- They may want to bracket their outcomes and have one scenario that works at 4% and another that works at 2.5% in real terms. With the lower return, they can also change some of their outcomes (i.e. retire later, work part time, leave a lesser estate, etc.).
- There is no reason they cannot get the average cash flow of their portfolio to between 3-5% after fees. It can easily be higher when they actually retire. If they do that, much of the risk of waiting for stock or other asset prices to rise is diminished.
What about the parents?
One thing the Brownings wanted us to do was to rerun her parents’ projections using more conservative assumptions. They were concerned, because unlike them, her parents could not work to earn capital to add to their savings or decide to retire later since they were already 71 and had been retired for five years.
Their basic facts were as follows:
- Both age 71, good health, retirement projections done to age 100
- $2,250,000 of investable capital outside of personal use real estate
- $100,000/yr. after tax income needed in $2012
- Want to leave investments intact in their estate in $2012
So what happens when we reduce their returns from 4% to 3%, or even 2%?
As the chart below shows, they will have a smaller estate to leave their children, but even at 2% their capital easily lasts to age 100 and beyond. If in fact we realized 2% for life, we could easily use prescribed annuities to eliminate all risk of running out of capital. In many ways lower future returns have less impact on them than their children.
The nominal assets assume a long-term inflation rate of 3% (the same as it has been for the last 100 years).
Performing in a bear market
Since this current secular bear market started in 2000, we have been able to average a net rate of return for clients of 4.2%/yr. after inflation and fees. However, over the last five years that rate of return was only 2.4%/yr. after fees and inflation.
While that is better than traditional balanced portfolios by about 4%/yr., it is still below our 4% real return objective.
Five years is a short time; and as we can see from the original data above, while traditional asset allocation models have achieved the 4% “real” result, they have gone for periods as long as 20 years underperforming that standard.
We believe that our asset allocation approach and execution will continue to perform better and with less volatility than these traditional models, but it only makes sense to have your personal retirement projection include your own version of “worst case scenarios.” Confronting these potential outcomes can help you better prepare and adapt, to make your planning work for you.
All markets have a tendency to revert to the mean. If they experience long periods of sub-par returns, then eventually they will recover and provide superior outcomes. We have expectations for the future, and they should be closer to great than grim.