Three Possible Outcomes for Future Investment Returns

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
User avatar
Topic Author
SimpleGift
Posts: 4477
Joined: Tue Feb 08, 2011 2:45 pm

Three Possible Outcomes for Future Investment Returns

Post by SimpleGift »

For a visual picture of the low-return world in which we now find ourselves, below is a chart of yields for three major asset classes over the last 30 years — the S&P 500 Index, the 10-year Treasury and the REIT Index. Seeing these declining yields converge together on one chart brings home just how high asset prices have become today, all across the board:

Image
(Sources: Shiller Database, NAREIT Equity REIT Index)

Looking ahead, there seems to be really only three possible outcomes going forward:
  • The New Neutral: Yields will stay at or near their current levels for years and possibly decades — resulting in portfolio returns that are permanently much lower than they have been historically.

    Reversion to the Mean: Yields will revert toward their historical averages, delivering higher long-term returns after the reversion — but as this occurs, investors will experience significant capital losses as yields rise.

    The Miracle: A permanent change in asset return fundamentals —for example, equity earnings growth will be sustainably stronger than in the past, making future stock returns much higher than current yields imply.
The first two outcomes seem at least plausible (and we can exclude the third outcome, I believe, short of divine intervention!). Therefore it appears that however the future unfolds, investors are either going to have to accept permanently lower investment returns or significant capital losses on the way to higher future returns. Your thoughts?
Last edited by SimpleGift on Wed Oct 22, 2014 7:22 pm, edited 2 times in total.
technovelist
Posts: 3611
Joined: Wed Dec 30, 2009 8:02 pm

Re: Three Possible Outcomes for Future Investment Returns

Post by technovelist »

My planning assumption is 0% real return. Anything above that is a bonus.
In theory, theory and practice are identical. In practice, they often differ.
bhsince87
Posts: 2914
Joined: Thu Oct 03, 2013 1:08 pm

Re: Three Possible Outcomes for Future Investment Returns

Post by bhsince87 »

I'd like to see that plot with real returns, instead of nominal.
Time is what we want most, but what we use worst. William Penn
ArthurO
Posts: 722
Joined: Sat May 24, 2014 12:25 pm

Re: Three Possible Outcomes for Future Investment Returns

Post by ArthurO »

technovelist wrote:My planning assumption is 0% real return. Anything above that is a bonus.
if you will be OK with 0% real why not just do CDs, like 10 or 20 years, brokered, and you will get the inflation return with no risk....
User avatar
Topic Author
SimpleGift
Posts: 4477
Joined: Tue Feb 08, 2011 2:45 pm

Re: Three Possible Outcomes for Future Investment Returns

Post by SimpleGift »

bhsince87 wrote:I'd like to see that plot with real returns, instead of nominal.
Ask and you shall receive — sorry, I was too lazy to deduct the annual inflation rate from the asset yields in the original chart. Not that it changes the premise or the conclusions of the original post, though.

Image
(Sources: Shiller Database, NAREIT Equity REIT Index)
bhsince87
Posts: 2914
Joined: Thu Oct 03, 2013 1:08 pm

Re: Three Possible Outcomes for Future Investment Returns

Post by bhsince87 »

Simplegift wrote:
bhsince87 wrote:I'd like to see that plot with real returns, instead of nominal.
Ask and you shall receive — sorry, I was too lazy to deduct the annual inflation rate from the asset yields in the original chart. Not that it changes the premise or the conclusions of the original post, though.

Image
(Sources: Shiller Database, NAREIT Equity REIT Index)
Thanks Todd! That was fast!

At least the second chart makes S&P yield look OK right now. But you're right, nothing else changes much.
Time is what we want most, but what we use worst. William Penn
bhsince87
Posts: 2914
Joined: Thu Oct 03, 2013 1:08 pm

Re: Three Possible Outcomes for Future Investment Returns

Post by bhsince87 »

I could also add, 2008 must have been a GREAT year for investors! :D
Time is what we want most, but what we use worst. William Penn
User avatar
Topic Author
SimpleGift
Posts: 4477
Joined: Tue Feb 08, 2011 2:45 pm

Re: Three Possible Outcomes for Future Investment Returns

Post by SimpleGift »

If some mean reversion of asset yields is in our future, this is how much today's current yields are below their average of the last 30 years (all nominal):
  • ………………….………Current.…Average..…DIFF
    S&P 500 Yield……..……2.0%…....2.4%…..…(18%)
    10-year Treasury………2.3%…….5.4%….….(58%)
    Equity REIT Index…...…3.4%…….6.4%…..…(47%)
Personally, I lean toward a future of persistently low asset yields and high valuations for the foreseeable future (The New Neutral). It's difficult to see where on the global horizon the growth and net demand for investment capital would come from to pressure real interest rates and earnings growth rates much higher. The advanced economies are now net savers (not net investors) on the world stage — and investment rates in the emerging economies are not yet high enough to drive an overall increase in global growth rates. (See this recent thread).

The world seems to be on a declining trajectory of GDP growth over the last decade that will take much higher global investment rates and consumer demand to reverse (chart below). This demand may eventually come from the emerging economies, based on their demographics alone — but we'll have to wait and see.

Image
Source: The Economist
Last edited by SimpleGift on Wed Oct 22, 2014 10:07 pm, edited 1 time in total.
User avatar
midareff
Posts: 7711
Joined: Mon Nov 29, 2010 9:43 am
Location: Biscayne Bay, South Florida

Re: Three Possible Outcomes for Future Investment Returns

Post by midareff »

Very interesting representation although total real return for the SP500 might be a more approprite illustrative tool. As a side note it certainly taints established portfolio surviveability withdrawal percentages. .... and thanks for the work Simplegift.
Rodc
Posts: 13601
Joined: Tue Jun 26, 2007 9:46 am

Re: Three Possible Outcomes for Future Investment Returns

Post by Rodc »

I am somewhat pessimistic over the intermediate term, notionally say 10 years. Much longer than that and almost anything could happen. Another stock crash could reset stocks even sooner, 10 year yields on ten year bonds not so much.

Your results are really, as you note, saying things now are all expensive. Corrections under such conditions are common. That does not help the lump sum investor (retired folks are effectively lump sum investors), but may help younger folks who still have lots of future investments to make after a correction, should one come.

I am somewhere in between, maybe more over on the lump sum side, but still putting in a fair amount and fortunately I have done ok on average over the years so I am not overly concerned. I don't think however I'll be in any golden age of returns like someone retiring in 1980.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.
stlutz
Posts: 5585
Joined: Fri Jan 02, 2009 12:08 am

Re: Three Possible Outcomes for Future Investment Returns

Post by stlutz »

The 1980s were in many ways perfect for bond investors--prices had the possibility of high inflation built in while actual inflation was much lower. Treating this perfect world as being a key part of the mean is not what I would do. Real rates a probably lower than what the future mean will be, but I wouldn't count on the 1980s scenario until there was a lot of pain preceding it (i.e. a replay of the 1960s and 1970s).
z3r0c00l
Posts: 3809
Joined: Fri Jul 06, 2012 11:43 am
Location: NYC

Re: Three Possible Outcomes for Future Investment Returns

Post by z3r0c00l »

ArthurO wrote:
technovelist wrote:My planning assumption is 0% real return. Anything above that is a bonus.
if you will be OK with 0% real why not just do CDs, like 10 or 20 years, brokered, and you will get the inflation return with no risk....
Because of taking risk for a chance at beating 0%
70% Global Stocks / 30% Bonds
User avatar
White Coat Investor
Posts: 17413
Joined: Fri Mar 02, 2007 8:11 pm
Location: Greatest Snow On Earth

Re: Three Possible Outcomes for Future Investment Returns

Post by White Coat Investor »

Simplegift wrote:
bhsince87 wrote:I'd like to see that plot with real returns, instead of nominal.
Ask and you shall receive — sorry, I was too lazy to deduct the annual inflation rate from the asset yields in the original chart. Not that it changes the premise or the conclusions of the original post, though.

Image
(Sources: Shiller Database, NAREIT Equity REIT Index)
Sure it does. The S&P 500 line is practically flat and the others are much reduced. Plus, this is a totally cherry picked time period beginning at the top of a long stock and bond bull market.

If you really think your portfolio is only going to give you 0% real, I suggest you find something else to invest in, like real estate. The yield on a paid off home purchaseable off the MLS should be in the 4-6% nominal range in many parts of the country. That's 2-4% real, not including appreciation. Returns should be higher if you use leverage. 30 year TIPS are yielding 1% real. You're suggesting that equities are going to have a lower return than a very safe asset like 30 year TIPS over your investment horizon?

You might say "I plan on 0% real and the rest will be gravy" but those kinds of choices carry real consequences- fewer vacations, less charitable donations, crappier cars bought further apart, a smaller house, kids go to a state school when they could have gone to an Ivy etc etc because you have to save more to make up for the lower returns.
1) Invest you must 2) Time is your friend 3) Impulse is your enemy | 4) Basic arithmetic works 5) Stick to simplicity 6) Stay the course
vencat
Posts: 276
Joined: Thu Sep 10, 2009 6:30 pm

Re: Three Possible Outcomes for Future Investment Returns

Post by vencat »

A more optimistic view from Eric Nelson/Servo investments:

http://www.servowealth.com/resources/ar ... ways-stink

Venkat
User avatar
Topic Author
SimpleGift
Posts: 4477
Joined: Tue Feb 08, 2011 2:45 pm

Re: Three Possible Outcomes for Future Investment Returns

Post by SimpleGift »

EmergDoc wrote:
Simplegift wrote:Not that it changes the premise or the conclusions of the original post, though.
Sure it does. The S&P 500 line is practically flat and the others are much reduced. Plus, this is a totally cherry picked time period beginning at the top of a long stock and bond bull market.
It's not the historical returns and the history of declining asset yields that matter (they're for illustration and context only). What matters is today's low yields and high asset prices. As discussed in the OP, today's yields can either, 1) stay low for a long while going forward with high asset valuations, or 2) revert toward their historical averages, with the attendant capital losses involved.

Either way, investors today are going to have to accept and plan for a lower return future. There just aren't any other plausible outcomes available that I can see — short of suspending the fundamentals of investment returns.
Last edited by SimpleGift on Wed Oct 22, 2014 11:50 pm, edited 1 time in total.
User avatar
TomatoTomahto
Posts: 17158
Joined: Mon Apr 11, 2011 1:48 pm

Re: Three Possible Outcomes for Future Investment Returns

Post by TomatoTomahto »

ArthurO wrote:
technovelist wrote:My planning assumption is 0% real return. Anything above that is a bonus.
if you will be OK with 0% real why not just do CDs, like 10 or 20 years, brokered, and you will get the inflation return with no risk....
He said it was his planning assumption, not his prediction. I want my plan to work out well enough at 0% real. I hope for 2-5% real, in which case I'll be living large.
I get the FI part but not the RE part of FIRE.
ctreada
Posts: 97
Joined: Tue Jun 10, 2014 1:35 pm

Re: Three Possible Outcomes for Future Investment Returns

Post by ctreada »

Whereas MILLIONS and MILLIONS of new investors have gotten just BASIC access to American markets over the last few decades, and MILLIONS more will do so in the future... my bet is that yields were artificially HIGH before and will only continue to drop as more people enter the market.

Historical means don't matter as much when the market HAD say 100m people in it 50 years ago and will have 2b people in it by 2020.

Just my two cents...
User avatar
galeno
Posts: 2653
Joined: Fri Dec 21, 2007 11:06 am

Re: Three Possible Outcomes for Future Investment Returns

Post by galeno »

Bonds are expensive. Equities are fairly valued in this low interest rate environment. My favorite guru, Dr. William Bernstein says bonds have a real expected return = 0%. Equities should deliver 3-4% real.
KISS & STC.
Clive
Posts: 1950
Joined: Sat Jun 13, 2009 5:49 am

Re: Three Possible Outcomes for Future Investment Returns

Post by Clive »

galeno wrote:Equities should deliver 3-4% real.
On average. For some - 20 years of 0%, for others - 20 years of 8%. The more recent decades have tended to be on the better side of that average.

1980 - 1999 TSM +12.5% real, combine that with
2000 - 2019 TSM -4.5% real and in combination 1980 - 2019 = +4% real average.
User avatar
VA_Gent
Posts: 235
Joined: Thu Jul 24, 2014 10:29 am

Re: Three Possible Outcomes for Future Investment Returns

Post by VA_Gent »

We have been here before. Scroll down and look at the 20 and 30 year rolling returns.

http://www.advisorperspectives.com/dsho ... oaster.php
"In investing, what is comfortable is rarely profitable." - Robert Arnott
richard
Posts: 7961
Joined: Tue Feb 20, 2007 2:38 pm
Contact:

Re: Three Possible Outcomes for Future Investment Returns

Post by richard »

1) The real question is today's prices compared to future earnings. For bonds, this is relatively easy - we know how much interest a bond will pay in the future (at least, if it's a very high quality bond such as a treasury). For stocks this is harder and we assume past earnings (typically past year or 10 years) are a good predictor of future earnings (or earnings growth). This assumption may or may not be true. That's a big reason why earnings yield (the inverse of p/e) is our best method, but only explains about 40% of the time variation in real returns.

2) If we're computing past actual real returns, subtracting past inflation from returns is correct. If we're trying to predict future real returns using past nominal returns, we should be subtracting expected inflation over the relevant period. That's easy if TIPS spreads (nominal treasury minus TIPS) are available and much harder if not.

Anyway, based on current yields, a reasonable assumption is 5% real for equities (p/e is around 20x) plus or minus 8%, and 0% real for bonds (10 year TIPS). If your assumptions are too conservative and you deprive yourself, too high and you won't have enough money.
User avatar
Topic Author
SimpleGift
Posts: 4477
Joined: Tue Feb 08, 2011 2:45 pm

Re: Three Possible Outcomes for Future Investment Returns

Post by SimpleGift »

midareff wrote:As a side note, it certainly taints established portfolio survivability withdrawal percentages...
Right! Those who are planning their retirement today should take a good look at Monte Carlo simulations that incorporate 1) today's low expected real asset returns, and/or 2) the effects of mean reversion to historical average real asset returns. A good place to start is this 2013 paper by Wade Pfau et al., The 4 Percent Rule is Not Safe in a Low-Yield World:
Wade Pfau et al. wrote: • The safety of a 4% initial withdrawal strategy depends on asset return assumptions. Using historical averages to guide simulations for failure rates for retirees spending an inflation-adjusted 4% of retirement date assets over 30 years results in an estimated failure rate of about 6%. This modest projected failure rate rises sharply if real returns decline.

• As of January 2013, intermediate-term real interest rates are about 4% less than their historical average. Calibrating bond returns to the January 2013 real yields offered on 5-year TIPS, while maintaining the historical equity premium, causes the projected failure rate for retirement account withdrawals to jump to 57%. The 4% rule cannot be treated as a safe initial withdrawal rate in today’s low interest rate environment.

• Some planners may wish to assume that today’s low interest rates are an aberration and that higher real interest rates will return in the medium-term horizon. Although there is little evidence to support this assumption, we estimate how a reversion to historical real yields will impact failure rates.

• Because of sequence of returns risk, portfolio withdrawals can cause the events in early retirement to have a disproportionate effect on the sustainability of an income strategy. We simulate failure rates if today's bond rates return to their historical average after either 5 or 10 years and find that failure rates are much higher (18% and 32%, respectively for a 50% stock allocation) than many retirees may be willing to accept.

• The success of the 4% rule in the U.S. may be an historical anomaly, and clients may wish to consider their retirement income strategies more broadly than relying solely on systematic withdrawals from a volatile portfolio.
User avatar
Chan_va
Posts: 870
Joined: Wed Dec 05, 2012 6:15 pm

Re: Three Possible Outcomes for Future Investment Returns

Post by Chan_va »

Can you post what method you are using to calculate yields? I don't see how real 10 year treasury yields have been negative for a majority of your time period
User avatar
Topic Author
SimpleGift
Posts: 4477
Joined: Tue Feb 08, 2011 2:45 pm

Re: Three Possible Outcomes for Future Investment Returns

Post by SimpleGift »

Chan_va wrote:Can you post what method you are using to calculate yields? I don't see how real 10 year treasury yields have been negative for a majority of your time period.
Hi, Chan_va. On the chart of real asset yields, you might be confusing the S&P 500 dividend yield (in blue) with 10-year Treasury yield (in green). It's easy to do, as the chart legend is tiny. The S&P 500 yield has indeed been negative in inflation-adjusted terms over much of the last 30-years — but the 10-year Treasury has only had negative real yields a few times lately.

All the yields and inflation data (except for the REIT yield, in orange), come from the multpl.com website.

PS. Also, as discussed upthread, it's not the past yield history that matters, but today's low yields and high asset prices. The chart of historical yields is just "eye candy" to give a bit of context for today's low return world.
User avatar
tennisplyr
Posts: 3703
Joined: Tue Jan 28, 2014 12:53 pm
Location: Sarasota, FL

Re: Three Possible Outcomes for Future Investment Returns

Post by tennisplyr »

Just curious, do you average US home prices over the time period? I know most here dont consider ones home as an investment.
“Those who move forward with a happy spirit will find that things always work out.” -Retired 13 years 😀
User avatar
Chan_va
Posts: 870
Joined: Wed Dec 05, 2012 6:15 pm

Re: Three Possible Outcomes for Future Investment Returns

Post by Chan_va »

Thanks Simplegift, I was looking at the wrong legend. For added color, here is some really long term data.

Here is the US 10 year yield from 1790. As you can see, the period from 1980 to present has been the greatest bull market in Bonds ever. This means that we the coming decades are going to be a terrible bond bear market right?

Image

Not so fast. Bond rates can go low, and remain low for looong periods of time. Longer than most of our investing horizons. Look at Japan. Yields on the Japanese 10 year bond have stayed below 2% for over 20 years now.

Image

Look at UK Gilts. Yields stayed historically low for over 50 years from about 1860 - 1910. So, don't rush out of your bonds just yet.

Image
User avatar
Topic Author
SimpleGift
Posts: 4477
Joined: Tue Feb 08, 2011 2:45 pm

Re: Three Possible Outcomes for Future Investment Returns

Post by SimpleGift »

Chan_va wrote:So, don't rush out of your bonds just yet.
Yes, the takeaway from low expected asset returns is NOT to give up on safe, lower-yielding bonds or to reach for more yield and return in riskier asset classes. Rather, investors should just expect that investment returns are likely to be lower than historical averages and plan accordingly, including:
  • • working longer
    • saving and investing more
    • reducing investment costs over the long haul
    • planning for a lower portfolio withdrawal rate in retirement
    • being frugal during retirement to make one's money last
    • consider taking on a bit of extra stock risk, consistent with one's risk tolerance
Better to prepare for lower returns, in my view, than to contemplate riskier investments in an effort to boost returns.
blueleaf
Posts: 134
Joined: Fri Dec 27, 2013 7:30 pm

Re: Three Possible Outcomes for Future Investment Returns

Post by blueleaf »

There are two things going in with the downward sloping s&p 500 line. One is higher valuation, as you've noted. The other is that companies are responding to US tax policy by directing less of their earnings to dividends and more to net buybacks. Since net buybacks generate shareholder value in a way that is very similar to reinvested dividends, it might be more informative to look at total shareholder yield rather than dividends alone. Alternatively, we might add a line for foreign developed large caps, which have maintained a more consistent share of earnings to dividends than have US companies.
User avatar
Chan_va
Posts: 870
Joined: Wed Dec 05, 2012 6:15 pm

Re: Three Possible Outcomes for Future Investment Returns

Post by Chan_va »

Simplegift wrote:.... Rather, investors should just expect that investment returns are likely to be lower than historical averages ....
I am not convinced that the concepts of historical averages and reversion to the mean make sense for the markets (and by extension, projection of future yields based on those). Because those measures change depending on your time period. The markets appear to follow a power law (the chart for a day indistinguishable from the chart for a decade if you didn't know the axis scale). For data like this, the averages keep changing depending on the length of the time period you choose, and never approach a limiting value.

It's true that there appears to be some long range order, but I prefer to think that the market just .. IS..
blueleaf
Posts: 134
Joined: Fri Dec 27, 2013 7:30 pm

Re: Three Possible Outcomes for Future Investment Returns

Post by blueleaf »

Simplegift wrote: Personally, I lean toward a future of persistently low asset yields and high valuations for the foreseeable future (The New Neutral). It's difficult to see where on the global horizon the growth and net demand for investment capital would come from to pressure real interest rates and earnings growth rates much higher.

It seems to me that a certain amount of mean reversion might be in order as central banks unwind their balance sheets. In the aftermath of 2008 they did everything they could to lower the cost of capital. It worked...yields fell dramatically (and asset prices rose). If they ever get around to normalizing, seems very possible that yields would drift up again (and asset prices would fall).
User avatar
abuss368
Posts: 27850
Joined: Mon Aug 03, 2009 2:33 pm
Location: Where the water is warm, the drinks are cold, and I don't know the names of the players!
Contact:

Re: Three Possible Outcomes for Future Investment Returns

Post by abuss368 »

ArthurO wrote:
technovelist wrote:My planning assumption is 0% real return. Anything above that is a bonus.
if you will be OK with 0% real why not just do CDs, like 10 or 20 years, brokered, and you will get the inflation return with no risk....
Hi ArthurO,

I would expect with many portfolio's, an investor runs the risks of having CD's in excess of FDIC insurance and may have to spread the CD holdings across many banks and financial institutions.

Best.
John C. Bogle: “Simplicity is the master key to financial success."
User avatar
Topic Author
SimpleGift
Posts: 4477
Joined: Tue Feb 08, 2011 2:45 pm

Re: Three Possible Outcomes for Future Investment Returns

Post by SimpleGift »

blueleaf wrote:Since net buybacks generate shareholder value in a way that is very similar to reinvested dividends, it might be more informative to look at total shareholder yield rather than dividends alone. Alternatively, we might add a line for foreign developed large caps, which have maintained a more consistent share of earnings to dividends than have US companies.
Good point, blueleaf. The S&P 500 dividend yield wasn't the most precise measure I could have used to show rising stock valuations and falling expected returns. Unfortunately, the stock shareholder yield (which includes the effect of net share buybacks) isn't a data series that's commonly available back to 1985, as best I know.

The best gauges of expected stock returns are the earnings yield (inverse of the price/earnings ratio) and the dividend discount model (aka the Gordon Equation). The International Monetary Fund has some data on historical expected returns for global stocks since 1973 (chart below). They attribute the declining expected returns primarily to much lower rates of investment in advanced economies and reduced investment profitability worldwide.

Image
(Note: Expected real stock returns are based on IMF dividend growth models.)
Source: International Monetary Fund
Rodc
Posts: 13601
Joined: Tue Jun 26, 2007 9:46 am

Re: Three Possible Outcomes for Future Investment Returns

Post by Rodc »

Simplegift wrote:
Chan_va wrote:So, don't rush out of your bonds just yet.
Yes, the takeaway from low expected asset returns is NOT to give up on safe, lower-yielding bonds or to reach for more yield and return in riskier asset classes. Rather, investors should just expect that investment returns are likely to be lower than historical averages and plan accordingly, including:
  • • working longer
    • saving and investing more
    • reducing investment costs over the long haul
    • planning for a lower portfolio withdrawal rate in retirement
    • being frugal during retirement to make one's money last
    • consider taking on a bit of extra stock risk, consistent with one's risk tolerance
Better to prepare for lower returns, in my view, than to contemplate riskier investments in an effort to boost returns.
That is a good list.

I would add something about keeping debt low or paying down debt especially in or near retirement, especially as inflation is low as well (countervailing point though is current interest rates are generally low).
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.
Post Reply