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Is the Past Prologue?

By Dan Tolomay, CFA


With the Standard & Poor’s 500 trading near all-time highs and bond yields remaining low, a natural question is, “what is the implication for future returns?”. Let’s take a look at: what has occurred in the past, what’s happening in markets now, and what we should expect and why.

From 1926-2017 U.S. bonds returned 5.35%, and U.S. stocks delivered 10.27% on average. During the same period, inflation averaged 2.91%. As a result, an investor in these assets would have earned between 5.35% and 10.27% in nominal (pre-inflation) terms or 2.44% to 7.36% on a real (inflation-adjusted) basis. A “balanced” portfolio of 60% stocks and 40% bonds (common among investors trying to fund a spending need and maintain purchasing power) would have provided 8.30% and 5.39% in pre- and post-inflation scenarios, respectively. The 5.39% real return would have allowed for withdrawals and covered all related costs.

None of us know the future, but we can use data to see what may play out over the next decade. While not a perfect predictor, looking at how expensive stocks are can be a good indicator of future long-term returns. Using historical data, U.S. equities are trading at a valuation level that implied a roughly 5.52% annual pre-inflation return over the next decade. Bonds, too, have a useful rule of thumb for estimating forward returns. There has historically been a close relationship between the ten-year Treasury note yield and the subsequent ten year return of the broad bond market. The 10-year yielded 2.51% at the end of April. The last piece of the puzzle is inflation. Breakeven inflation, which is the inflation rate that is priced in by the market where Treasury and Inflation-Protected Treasury notes provide the same real return, is 1.95%.

Looking ahead, then, an all bond portfolio might provide 2.51% pre-inflation return and an all stock portfolio could produce 5.52% of pre-inflation return. After inflation, the numbers drop to 0.56% and 3.57%, respectively. A 60/40 portfolio delivers 4.32% before inflation and 2.37% after inflation. Obviously, these implied returns provide less for portfolio draws and cost coverage.

What’s an investor to do?

Confirm asset allocation. A comparison of an account’s present value to its desired future value combined with a time horizon allows for a return goal to be defined. By comparing the required return to the expected return, tweaks may be necessary to a portfolio’s asset mix to reconcile the two. It is critical that risk is considered as well as return. Higher returns come with more volatility. If the portfolio is unable to tolerate the swings or if volatility causes the investor to deviate from plan, then risk is too high.

Focus on controllable factors. The account’s asset allocation will determine its return. And, while the current value cannot be changed, other levers can be pulled. The future value is one. The original goal may be too lofty and may require revision. A review of future spending plans is a healthy exercise. Alternatively, the goal may be left as is and the time horizon extended. Allowing funds more time to grow before use can offset lower potential returns. Lastly, the account can be funded at higher levels. More money growing at a lower rate can achieve the same goal as less money grown at a higher percentage.

Think bigger. The analysis thus far has focused on the U.S. only. However, nearly half of the global stock market lies beyond the borders. Those markets are trading at lower valuations and have higher expected returns than American shares. Diversifying globally increases the expected return on stocks. Similarly, the majority of the taxable bond market exists internationally. By not exposing all fixed income exposure to the United States’ yield curve and inflation environment, volatility can be lowered and returns can be potentially enhanced.

Think smaller. Looking at valuations and implied returns across the globe is helpful, and so is looking within markets. In the United States and developed international markets, the better buys (and, thus, higher implied results) lie in smaller companies and value stocks. Both have greater expected returns than their broad market measures.

Eliminate unfavorable odds. Harry Markowitz (Nobel Laureate) called diversification “the only free lunch in finance”. Holding a portfolio of only one or just a few stocks yields higher risk than potential reward.  This type of concentration risk is easily diversified away. Further, research shows that the vast majority of conventional active managers fail to outperform their benchmarks after cost. Trying to outsmart the collective market tilts the odds away from your favor. Lastly, there is a clear relationship between costs and returns. The more you pay, the less you keep.  Thus, keep costs low.

We cannot know what the future holds. What we can do is look at what’s happened historically and at what might occur based on current market fundamentals. Setting and sticking to a plan based on portfolio-specific circumstances and adapting as necessary is a key first step. Diversifying across and within markets, targeting higher expected returns is next. And, lastly, by avoiding unnecessary risks and minimizing costs, more return – whatever it ends up being – accrues to your bottom line.

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