How Do You Create Success Simply...in Challenging Markets?
Congratulations. You’ve done an amazing job as an attorney, pro-athlete or similar high-end professional. You’re still hard at work, but the rewards are finally rolling in. Your income has reached stellar levels and, as long as you keep at it, the future looks bright.
Now what? Even if you love life in the fast lane, eventually, you’ll probably want to ease off the accelerator. You might want to shift gears, leveraging all you’ve learned to become a adjunct professor or consultant. Or maybe it’s a U-turn to pursue some dream venture: opening a winery, an art gallery or a coffee house. Or, you may want to retire to travel the world, spend time with the grandkids, volunteer in your community, or just chill out.
If you’ve created a successful career, you probably already know how to actualize your greatest goals. It’s called planning. Your planning need not be complicated. In fact, simple plans are often the strongest, especially when they include remaining clear-eyed about the challenges involved. Let’s explore some of the investment challenges attorneys and other high-end professionals face, as well as several cogent ways to address those challenges.
Converting Income to Wealth
First, the good news: With some sensible planning, successful professionals enjoy better-than-average odds of converting their satisfying income into a well-structured investment portfolio, tailored to fund their future goals.
But there’s also a dilemma. On the one hand, we must create an investment plan for how much market risk you want to accept (or avoid) in pursuit of higher-expected stock returns (or to safeguard existing wealth). On the other hand, we don’t know for sure whether your plan will work. Nobody knows what the future holds, for you or for market returns.
That said, we’ve got to start somewhere. As such, estimating expected future returns is essential to planning … and planning is essential to giving yourself the highest odds for funding your life’s goals. In his ETF.com article, “Toss Your Expectations,” Larry Swedroe suggests: “Because we must develop financial plans without the benefit of a clear crystal ball, we should use the best tools available.”
In the absence of a soothsayer, what do those “best tools available” tell us about future expected returns?
Markets and Expected Returns
Let’s turn to another Swedroe ETF.com post, “4 Horsemen of Your Portfolio.” As the title suggests, the evidence is a little grim for future expected returns, at least relative to the historical returns we’ve enjoyed in the past. To summarize, Larry cites four apocalyptic “horsemen” that, left unmanaged, could trample your lifelong wealth:
- Historically higher equity valuations
- Currently lower bond yields
- Increasing human longevity
- Increasing need for expensive long-term care
For today, we’ll set aside a detailed conversation about the last two horsemen, i.e., that our life expectancies are increasing, even as long-term healthcare costs are also on the rise. Suffice it to say we need to factor in the very real possibility that one or both of you may live well into your 90s, and require extended medical or daily-living care along the way. This is especially the case for successful, affluent families who have been living relatively healthy lifestyles. The numbers can dramatically affect your portfolio planning.
Let’s take a closer look at those historically higher returns, and what they mean to future expected returns:
From 1926–2017, the S&P 500 returned about 10.2% annually[WC1] . Many investors naively extrapolate historical returns when estimating future returns. That can be a bad mistake. Some of the return to stocks was a result of a declining equity risk premium, resulting in higher valuations. Higher valuations now forecast lower future return expectations over the next 10 years.
Using the Shiller cyclically adjusted price-to-earnings (CAPE) 10 ratio as a preferred metric for estimating future returns, we are estimating forward-looking nominal equity returns in the range of about 5%, or about half the historical level.
Similarly, let’s look at expected bond yields, where the current yield is typically assumed to be the best predictor for future expected returns:
From 1926–2017, the five-year Treasury bond returned 5.1% annually, and the long-term (20-year) Treasury bond returned about 5.5%. Current yields on those two Treasury securities are just 2.5% and 2.8%, respectively.
Combining these two concepts into a “typical” 60% stock/40% bond portfolio, we calculate historical annual returns in the range of 8.5% if we go back 90 years, or 10.2% if we look back 36 years. Looking forward, using a more aggressive 6% expected return to stocks, a 60/40 allocation would only provide an expected return of 4.6% given the low yield on safe bonds
Lest you conclude that we’re just grumpy pessimists, let me assure you, most other evidence-based strategists we’re aware of are currently making similar assumptions. To varying degrees, the rest of our colleagues among THE BAM ALLIANCE, as well as fund managers AQR, Stone Ridge and Dimensional Fund Advisors are collectively expecting lower future returns for today’s typical 60/40 stock/bond portfolio.
Some Comforting Caveats
Before you despair, let me also assure you lower expected returns does not mean all is lost. As we touched on earlier, the most likely path to success is found by being crystal clear about the challenges you’ll face. That way, we can best figure out what to do about them.
Also, let’s get one thing straight: An above-average CAPE 10 says nothing about the market being overvalued. Neither the CAPE 10 nor anyone else’s valuation methodology, can tell you when and where a rising market will top out, or a falling market will turn to the upside. Do not sell and get out of the market. Blowing up your plan can have long-term repercussions from which you may not recover.
So what should you do when investing in a market with lower expected future returns?
Question the Status Quo – First, knowing a typical 60/40 stock/bond portfolio may disappoint, simply put, consider a different portfolio. I’ve covered a solution here for wringing higher expected returns out of the market risks involved; to summarize, you can:
- Shift to a bigger slice of less-risky, high quality bonds in your portfolio.
- Tilt your smaller slice of equity toward higher expected returns (which also means higher risks). Think small-cap and value companies.
- Further manage your risk/return expectations by including a low- or no-correlation allocation to “consumer friendly” alternatives as additional sources of return.
Keep Your Eye on the Ball – While we do our best to establish realistic return expectations, actual outcomes remain far from certain. As AQR expressed in this white paper on return estimates: “Any responses to expected return estimates should consider the breadth of possible outcomes as well as the midpoint.” In short, your best-laid investment plan should reflect the likelihood that your return expectations will either over- or under-shoot their precise target. Shiller’s CAPE 10 is a tiny target in a very large field of possibilities! This brings us to our final point …
Plan for a Plan B – If you’re a successful professional, you already know: It’s not enough to create an all-or-nothing plan. You also want a “Plan B” ready and waiting, just in case. For investing, your Plan B should be a written agreement between you and your advisor, listing the specific actions you’re prepared to take if your financial assets drop below a defined level. Your actions might include working longer, lowering your cost of living, downsizing your retirement goals, or a mix-and-match combination. Make sure you’re truly prepared to perform the actions if needed. If deep down, you know you’d be emotionally devastated by the sacrifices, keep working on your Plan B until you come up with a set of tradeoffs you could actually live with.
By the way, you also can have Plan B actions for if your portfolio performs better than expected. That’s a nice “problem” to have, and who knows, it could happen to you!
If you could use help with any of your financial planning, there is one thing you can plan on. We’re here to have a Cogent Conversation® with you.