what low real rates mean for stock returns

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larryswedroe
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what low real rates mean for stock returns

Post by larryswedroe »

Thought this would be of interest.
Has major implications for those projecting historic real return for stocks, let alone bonds



http://www.cbsnews.com/8301-505123_162- ... or-stocks/

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Re: what low real rates mean for stock returns

Post by Call_Me_Op »

Larry,

Does this make international investing [even] more appealing?
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Re: what low real rates mean for stock returns

Post by gt4715b »

Any idea on what low real rates mean for the value and small cap premia? Would these be expected to be lower as well?
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Re: what low real rates mean for stock returns

Post by larryswedroe »

few thoughts
US returns relative to international: would look at valuation metrics like BtM, PE, and so on to figure that out. Or Gordon model. All indicate higher international returns should be expected --of course that likely reflects greater risk associated with it

As to premiums, answer similar. What determines their size is the spread between the valuations of growth and value stocks, like P/E spreads or BtM spreads. The wider the larger the expected premium.

Larry
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Re: what low real rates mean for stock returns

Post by Artsdoctor »

I'm actually a little surprised that this thread has not garnered more attention.

Using whatever equation or ratio you want, the outlook for stock market returns for the foreseeable future is almost certainly going to be meager and quite low by historical averages. And real returns on bonds are definitely go to be low, if not zero or negative.

You have to have some sort of goal for what it would take to create a comfortable environment once you stop working, and then you have to calculate just how you're going to get there. That's one of the first steps in stepping up an investment plan, right? Using the numbers here, a 50/50 portfolio would generate a real rate of return of about 2% (2.5% if things go well). This is what I've been using for my planning but every time I mention this to my colleagues and friends, they think I'm crazy (clearly, state pension plans would scoff at the numbers in Larry's article).

There have been threads posted here in the past although I think it's been a while; I'm curious if Bogleheads are counting on anything more than 3-3.5% real return for investments into the foreseeable future. And for those of us in the 50/50 camp, I'm wondering if anyone is using more than 2.5% in calculating their investment plans.

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Re: what low real rates mean for stock returns

Post by larryswedroe »

artsdoctor
Those pension plans may scoff but one day the accounting world is going to force them to justify the returns they are forecasting.
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Re: what low real rates mean for stock returns

Post by White Coat Investor »

Wade Pfau's recent column on this also suggests 2% real. 2% real has all kinds of retirement planning implications. For instance, it may no longer be worth it to retire early simply because of the massive savings rates required to do so. At a certain point it becomes far easier to have a job than to try to earn money investing. It also makes insurance-based investing products look more favorable. Honestly, if I thought my portfolio would only earn 2% real going forward, I'd be buying investment real estate properties instead of stocks and bonds.

I plan on 5% real, but I monitor it very carefully and if I find I'm not reaching that (9 years into my investing career I still am), I'll change the plan accordingly.

The truth of the matter is that all lifestyle is relative anyway. If I only get 2% real and thus have less in retirement, as long as everyone else has less I probably won't notice. The prices of the stuff I want to buy will stay low because no one else can afford them either. Que sera sera. It doesn't do any good to worry about it. Boglehead investing is about taking what the market offers. If that's 2% real, well, that's what I'll retire on (although it'll probably be a few years later and/or on less money than planned.)

Larry- I liked your last paragraph. But your chart was pretty darn cherry-picked. An oddball 12 year period? And using the worst equity asset class you could have? I expect more of you.
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Re: what low real rates mean for stock returns

Post by hoppy08520 »

EmergDoc wrote:The truth of the matter is that all lifestyle is relative anyway. If I only get 2% real and thus have less in retirement, as long as everyone else has less I probably won't notice. The prices of the stuff I want to buy will stay low because no one else can afford them either. Que sera sera.
Yes, I've thought that too about these gloomy forecasts. More on this theme from W. Bernstein: http://www.efficientfrontier.com/ef/103/hell4.htm.
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Re: what low real rates mean for stock returns

Post by steve roy »

Predictions based on current data are generally off a bit, and the farther out the prediction, the more inaccurate it tends to be. Remember the Club of Rome's dire predictions for the world economy in the late seventies? They didn't quite pan out in the dire way CoR thought they would. And a lot of Keynesian economists predicted a major U.S. recession when government spending slowed down at the end of WWII. They turned out to be wrong, but unemployment DID double ... from 1.45% to 3.2%.

I agree with Larry that real returns will be lower than today. But I agree with Emergdoc that the population will trim its sails accordingly. I'm also convinced the future will likely end up a LOT different than most of us now imagine.
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Re: what low real rates mean for stock returns

Post by larryswedroe »

EmergencyDoc
The 12-year period of course was cherry picked, it was done so to make the point that you have to be very careful about using historical data to project future returns. You have to consider the valuations/yields at the starting and end points. I believe the post makes that very clear in the paragraph right below it

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Re: what low real rates mean for stock returns

Post by ResNullius »

Artsdoctor wrote:There have been threads posted here in the past although I think it's been a while; I'm curious if Bogleheads are counting on anything more than 3-3.5% real return for investments into the foreseeable future. And for those of us in the 50/50 camp, I'm wondering if anyone is using more than 2.5% in calculating their investment plans.

Artsdoctor
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Re: what low real rates mean for stock returns

Post by richard »

In theory, a stock is worth the present value of future cash flows. All else being equal, when rates are lower, present values are higher.

A question is whether all else is equal. If low rates correlate with lower future cash flows, then we should not necessarily expect higher present values, as the lower discount rates raise present values, but lower cash flow lower those values.

All of which is another example of the old saying, predictions are tough, especially about the future.
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Re: what low real rates mean for stock returns

Post by Call_Me_Op »

Larry,

Does your analysis account for the fact that investment dollars need to go somewhere - meaning if bond yields remain very low, that makes equities more attractive (since the equity premium is not cast in concrete)? Perhaps this will produce a future bubble in equities.
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Re: what low real rates mean for stock returns

Post by scone »

EmergDoc wrote:Wade Pfau's recent column on this also suggests 2% real. 2% real has all kinds of retirement planning implications. For instance, it may no longer be worth it to retire early simply because of the massive savings rates required to do so. <snip>
You say that like it's a bad thing. :) There is a whole subculture of "extreme savers" out there who are retiring early and quite pleased about it. In any case, very high savings rates, it seems to me, may be the only safe option for many people, if they want to retire.
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Re: what low real rates mean for stock returns

Post by Grt2bOutdoors »

scone wrote:
EmergDoc wrote:Wade Pfau's recent column on this also suggests 2% real. 2% real has all kinds of retirement planning implications. For instance, it may no longer be worth it to retire early simply because of the massive savings rates required to do so. <snip>
You say that like it's a bad thing. :) There is a whole subculture of "extreme savers" out there who are retiring early and quite pleased about it. In any case, very high savings rates, it seems to me, may be the only safe option for many people, if they want to retire.
Sometimes these very high savings rates are the result of a lifetime of seeing daily struggles and wanting to avoid the same misfortune. In other words, these savers are taking proactive steps to mitigate bad outcomes resulting from things beyond their control - a job loss, seasonal work, health issues, lack of a network support (no family), etc.
My parents had seasonal work for a number of years, 6 or 7 months of work, then 5 or 6 months of unemployment - you quickly learn the value of a dollar when exposed to that scenario. Their not thinking about retirement, their thinking about survival of family unit.
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Re: what low real rates mean for stock returns

Post by Random Musings »

Larry,

With respect to valuations in the equity markets and current interest rates, and there any pension plans out there that utilize this information to help determine a reasonable forecast? There has to be a few groups out there that "get it".

RM
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Re: what low real rates mean for stock returns

Post by huntertheory »

Low real interest rates will pull down the expected return on risky assets like the force gravity.
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Re: what low real rates mean for stock returns

Post by richard »

huntertheory wrote:Low real interest rates will pull down the expected return on risky assets like the force gravity.
Low real interest rates are a symptom of a slow economy, which would be expected to result in lower returns.

Low real interest rates make it cheaper to borrow, encouraging economic activity that boosts returns, makes safe assets less desirable, increasing the demand for and therefore the prices of risky assets and, as I mentioned earlier, raises the present value of future cash flows. Higher prices for risky assets encourage the creation of risky assets, in other words, more potentially productive economic activity.

There's a reason the Fed traditionally lowers rates to stimulate the economy. A better economy should result in better returns for risky assets.
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Re: what low real rates mean for stock returns

Post by Levett »

"And for those of us in the 50/50 camp, I'm wondering if anyone is using more than 2.5% in calculating their investment plans."

2.5% real?

If real, that's in the range of my expectations.

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Re: what low real rates mean for stock returns

Post by larryswedroe »

RM
Perhaps but I'm not aware of them. However, we are seeing them move down toward more realistic assumptions., They would move to reality IMO if it was not so painful (either in terms of earnings hits or budget implications). But you can only deny reality for so long
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Re: what low real rates mean for stock returns

Post by EDN »

I took a quick glance at the evidence for US stocks and balanced portfolios over periods of time where we've had positive and negative real rates. The results strongly conflict with the evidence from other studies:

First, we know we've had two major periods going back to the early 1940s: from 1942-1981, interest rates rose almost non-stop, and all bonds had negative real returns for the entire period. Since 1982, of course, the situation has flipped.

From 42-81,
--CPI ran 4.6%,
--t-bills earned 3.7%,
--Total Bond (5YR T-Notes prior to 1973) earned 3.5%
--LT bonds earned 2.3%
--CRSP 1-10 Index earned +11.6% per year, or 7% real, and 8% in excess of the risk free rate
--A tilted stock allocation* earned +14.2% per year, or 9.6% real and 10.5% in excess of the risk free rate
--A balanced 60/40 allocation** earned +10.4% per year, about 6% real and about 5.5% in excess of the risk free rate

From 82-12,
--CPI ran 2.9%,
--t-bills earned 4.5%,
--Total Bond (5YR T-Notes prior to 1973) earned 8.8%
--LT bonds earned 10.8%
--CRSP 1-10 Index earned +11.0% per year, or 8% real, and 6.5% in excess of the risk free rate
--A tilted stock allocation* earned +12.5% per year, or 9.6% real and 8% in excess of the risk free rate
--A balanced 60/40 allocation** earned +11.4% per year, about 8.5% real and about 7% in excess of the risk free rate

So stocks (CRSP 1-10 and Tilted Stock Index) actually had higher returns in excess of the risk free rate during the stretch of negative real rates, about the same real returns in both periods. The balanced portfolio did a bit better during the period with positive real rates (due to 40% in bonds), but very good in both.

Now, maybe this 2 period sample is biased towards one or two really good years. So instead, I looked at all rolling 12 month periods of negative real returns for 1mo t-bills from 1942-2012. I found that TSM earned +13.1% on average (not annualized) when real t-bill returns were positive, +12.5% when real t-bill returns were negative. The 60/40 balanced portfolio earned +11.5% and +11.6% -- exactly the same whether real t-bill returns were positive or negative.

There is a lot that goes into stock and bond returns. I think focusing on real rates is but one input and we shouldn't draw any meaningful conclusions from it.

Eric

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Re: what low real rates mean for stock returns

Post by larryswedroe »

eric
You happened to choose periods that both began with exceptionally high ERPs ex ante. The valuations were very low, very low P/Es which mean high expected returns. You have to consider that as well. That certainly is not true today. Depending on how you look at things: If you use current valuations, they look about average. If you use the Shiller P/E you get very high valuations (and low expected returns).

While I don't have the E/P from 42 I believe it was very low. And in 81 it was over 12%, way above today's levels
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Re: what low real rates mean for stock returns

Post by midareff »

Levett wrote:"And for those of us in the 50/50 camp, I'm wondering if anyone is using more than 2.5% in calculating their investment plans."

2.5% real?

If real, that's in the range of my expectations.

Lev
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Re: what low real rates mean for stock returns

Post by EDN »

larryswedroe wrote:eric
You happened to choose periods that both began with exceptionally high ERPs ex ante. The valuations were very low, very low P/Es which mean high expected returns. You have to consider that as well. That certainly is not true today. Depending on how you look at things: If you use current valuations, they look about average. If you use the Shiller P/E you get very high valuations (and low expected returns).

While I don't have the E/P from 42 I believe it was very low. And in 81 it was over 12%, way above today's levels
Larry
OK, a few things:

#1 Even so, that is another input, and to my point, real IRs alone shouldn't be counted on for anything. Your inclusion of additional valuation data supports that.
#2 Those are also very high returns I showed, much higher than even the returns that some are saying are too high. So higher valuations today don't mean dismal outcomes, just not as high as those really high historical returns.
#3 There are all sorts of valuation measures, and depending on the selection or smoothing method, we can convince ourselves of anything: overvalued, undervalued, etc. How about fairly or average value?

If we look at the 40 years ending in 2012 (1973-2012), we find the following average BtM ratio (and current) for the French 2X3 grid:

US LG = 0.3 (0.3)
US LB = 0.8 (0.7)
US LV = 1.3 (1.4)
US SG = 0.3 (0.3)
US SB = 0.8 (0.7)
US SV = 1.6 (1.4)

If you can see any difference between today's valuation across asset classes (instead of the S&P dominated metrics we're usually left with) and the 40 year average, you have better eyes than met. Things today are just as average as average gets.

Over this period (1973-2012), incidentally, the CRSP earned +5.6% real, the tilted stock index earned +8.0% real, and the tilted balanced index earned 6.7% real. Now interest rates are lower today, so I'm all for lowering the expectations for balanced portfolios because bonds won't do what they have, but I'm not ready to relegate a small/value tilted equity portfolio to the doldrums of dismal future returns just yet. About the most actionable advice we can presume from low real bond rates is: don't go overboard with bonds.

Eric
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Re: what low real rates mean for stock returns

Post by larryswedroe »

Eric
First, of course valuations matter. You can have very low real rates and P/Es of say 25 which would predict low returns or PEs of 5 which would predict high returns.
Second, What I have noted is that real rates are low and depending on how you look at things valuations (market) are either at best about average (I was looking at P/Es--don't use BtM in Gordon Model--but get same result, about average) and at worst (CAPE) very high. But even very high figures don't guarantee negative returns, or even very low ones, but the best outcomes are much lower and the worst outcomes much worse when valuations are high. So IMO it seems very prudent to plan on lower than expected returns and if you get lucky great. Note the forecasts by Dimson, Marsh and Stanton are in line with those of Fama/French and most other academics I have read. And about what we are using in MCS simulations for planning purposes.
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Re: what low real rates mean for stock returns

Post by EDN »

larryswedroe wrote:Eric
First, of course valuations matter. You can have very low real rates and P/Es of say 25 which would predict low returns or PEs of 5 which would predict high returns.
Second, What I have noted is that real rates are low and depending on how you look at things valuations (market) are either at best about average (I was looking at P/Es--don't use BtM in Gordon Model--but get same result, about average) and at worst (CAPE) very high. But even very high figures don't guarantee negative returns, or even very low ones, but the best outcomes are much lower and the worst outcomes much worse when valuations are high. So IMO it seems very prudent to plan on lower than expected returns and if you get lucky great. Note the forecasts by Dimson, Marsh and Stanton are in line with those of Fama/French and most other academics I have read. And about what we are using in MCS simulations for planning purposes.
Forewarned is forearmed
Larry
Larry,

If those "forecasts" conclude the 3% to 3.5% ERP or real equity returns going forward that your article quoted, I think that is excessively low. Could happen, but not as a base case.

The 73-12 geometric ERP was 4.6%, and it was only that low because 1mo t-bills earned > 4% (stock returns were identical to 1926-1972). Real stock returns were 5.6%, just a hair lower than the 6% return we've seen since 1900 and spot on with the world market portfolio real return over this period.

My gripe with these "expected return" discussion is, what stocks? The 0.3/0.3 US allocation I mentioned above outpaced TSM by almost 250 bps over this period. So were now talking about a Tilted Stock ERP of almost 7% for this stretch, and 8% real that everyone seems to scoff at. And what about Int'l? Much lower valuations than US, so 8% real might even be the baseline with higher potential. And, of course, EM isn't expensive and probably deserves a risk premium in the first place--add a size/value tilt and 10% real may not be unreasonable. Then, finally, thanks to diversification return, balanced portfolios that are reset periodically routinely earn 0.5% to 1% more than the weighted average of their components. All this adds up to a fairly optimistic future, not the doom/gloom some portend.

I agree you don't plan for best case scenario, you weight bad, good, and average accordingly and have a plan for the worst. I just take issue with these dire forecasts...bonds? Sure, but that's about it.

Eric
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Re: what low real rates mean for stock returns

Post by grap0013 »

EDN wrote: My gripe with these "expected return" discussion is, what stocks? The 0.3/0.3 US allocation I mentioned above outpaced TSM by almost 250 bps over this period. So were now talking about a Tilted Stock ERP of almost 7% for this stretch, and 8% real that everyone seems to scoff at. And what about Int'l? Much lower valuations than US, so 8% real might even be the baseline with higher potential. And, of course, EM isn't expensive and probably deserves a risk premium in the first place--add a size/value tilt and 10% real may not be unreasonable. Then, finally, thanks to diversification return, balanced portfolios that are reset periodically routinely earn 0.5% to 1% more than the weighted average of their components. All this adds up to a fairly optimistic future, not the doom/gloom some portend.

I agree you don't plan for best case scenario, you weight bad, good, and average accordingly and have a plan for the worst. I just take issue with these dire forecasts...bonds? Sure, but that's about it.

Eric
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Re: what low real rates mean for stock returns

Post by grap0013 »

It's interesting to think of expected stock returns in isolation based on valuations vs. expected returns in relation to the risk free rate.

Here's a hypothetical scenario/question: Let's say interest rates rise 3% over the next 5 years and stock valuations are similar to today's based on PE. What does this do to your 30 year equity return projections in 2018? Are they 3% higher?

Thanks!

grap
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Re: what low real rates mean for stock returns

Post by larryswedroe »

Grap
This is the money illusion problem
If rates rise they rise for basically one of two reasons. The first is inflation rises. If that happens corporate earnings should basically rise by about same rate. So nominal returns go up but not real. So no change in the risk premium. The other is real rate rises. Assuming that is for higher economic growth then corporate earnings should rise by about same rate. So again, no change in ERP.

Eric
The 4-5% real annual average premium is in line with what Fama and French found in their own study years ago as the ex-ante premium investors expected. It turned out that it was higher by luck. So the current forecasts are not out of line. And certainly in line with what most academics are forecasting. So you are certainly free to believe it's likely to be higher.

And yes of course your AA matters. We make forecasts for what we call different Risk Targets (each RT effectively has loading of about that for each factor) . So a RT 1 has roughly 10% loading on size and value and a RT6 would have roughly 60% loading, with each RT up adding about 80bp in expected returns. The more you tilt, the lower the equity exposure (and the lower the tail risk) one needs to achieve their financial goal--of course the more tracking error risk one takes. My own portfolio is of course RT6. Our annual average forecast for example of RT6 is about 12%, which given an SD of roughly 20% would get you a compound return of about 10%. For the market it would be roughly 8% annual average and 20% lower for compound.

Best wishes
Larry
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Re: what low real rates mean for stock returns

Post by grap0013 »

larryswedroe wrote:Grap
This is the money illusion problem
If rates rise they rise for basically one of two reasons. The first is inflation rises. If that happens corporate earnings should basically rise by about same rate. So nominal returns go up but not real. So no change in the risk premium. The other is real rate rises. Assuming that is for higher economic growth then corporate earnings should rise by about same rate. So again, no change in ERP.

Eric
The 4-5% real annual average premium is in line with what Fama and French found in their own study years ago as the ex-ante premium investors expected. It turned out that it was higher by luck. So the current forecasts are not out of line. And certainly in line with what most academics are forecasting. So you are certainly free to believe it's likely to be higher.

And yes of course your AA matters. We make forecasts for what we call different Risk Targets (each RT effectively has loading of about that for each factor) . So a RT 1 has roughly 10% loading on size and value and a RT6 would have roughly 60% loading, with each RT up adding about 80bp in expected returns. The more you tilt, the lower the equity exposure (and the lower the tail risk) one needs to achieve their financial goal--of course the more tracking error risk one takes. My own portfolio is of course RT6. Our annual average forecast for example of RT6 is about 12%, which given an SD of roughly 20% would get you a compound return of about 10%. For the market it would be roughly 8% annual average and 20% lower for compound.

Best wishes
Larry
Thanks Larry! Not to sidetrack this thread, but what is your expected return for the Bridgeway Omni SCV fund BOSVX?
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Re: what low real rates mean for stock returns

Post by larryswedroe »

grap, on order of 10%
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Re: what low real rates mean for stock returns

Post by Mitchell777 »

If 2.5% real for a 50/50 mix were to be the norm for a very long time, it may mean needing to save a lot more money. If I recall the paper Dr Pfau did on safe withdrawl rates if the real returns going forward are very low, 30 years was in the 2.5% to 2.8% range and 40 years in the 1.9% to 2.3% range (with risk of running out of money varying from 1% to 10%). Those numbers were based on bonds earning 1% real and stocks 4% real.
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Re: what low real rates mean for stock returns

Post by larryswedroe »

Mitchell
That is exactly the implication. Many individuals should be planning on either working longer, saving more, or lowering their goal.
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Re: what low real rates mean for stock returns

Post by dkturner »

larryswedroe wrote:eric
You happened to choose periods that both began with exceptionally high ERPs ex ante. The valuations were very low, very low P/Es which mean high expected returns. You have to consider that as well. That certainly is not true today. Depending on how you look at things: If you use current valuations, they look about average. If you use the Shiller P/E you get very high valuations (and low expected returns).

While I don't have the E/P from 42 I believe it was very low. And in 81 it was over 12%, way above today's levels
Larry
At the end of 1942 the P/E ratio of the S&P 500 was 9.2. In 1949, when interest rates really bottomed out, the P/E of the S&P 500 was only 7.1.
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Re: what low real rates mean for stock returns

Post by Artsdoctor »

Isn't predicting an estimated real rate of return one of the basic premises of investing? I'm not sure I agree with the statement that being a Boglehead is just about taking what the market offers. I think that this forum gives you the tools to make reasonable investment decisions in order to meet your financial goals. Expecting 5-10% real rate of return over a lifetime of investing would be great! But this forum and the financial academic world would caution you that you might want a Plan B if that does not happen.

Am I getting this backwards? If I anticipate a 2-2.5% real rate of return going forward and I plan accordingly, I think I have a "reasonable" likelihood of meeting my goals. If the real rate of return over many years turns out to be 5%, I can take several month-long safaris, as opposed to spending time in New York seeing shows during my golden years. I'll be able to eat out more often and finance loved ones' education more freely. But if I plan on a 5% real rate of return, save accordingly, and then find out that the real rate of return winds up being 2.5% after the fact, I'm going to take a real cut in my quality of life. How much are you willing to gamble?

The crux of the argument has to be about making a reasonable expectation of how much to save based on your ability and risk tolerance, sock away that amount every month, and only after you've met those obligations do you spend in real time. Yes, you can adjust things accordingly based on valuations, your success, and your health. The real gift of being a Boglehead is not just taking what the market has to offer, but to invest with your eyes wide open and lead your life right now accordingly. I remember investing in the late 1990s when the "fad" was predicting a 10-12% rate of return year after year for the rest of your investing career. This forum saved my family and me from falling into that trap! We can't control the craziness of the market but we can definitely make an effort to control the amount we save.
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Re: what low real rates mean for stock returns

Post by kermit »

I'm 27 years old and maintain a 60/40 ratio. Vanguard says this returns on average 8.6%: https://personal.vanguard.com/us/insigh ... llocations. Even with modest inflation this isn't nearing the 2.5% real some of you are throwing around for similar portfolios.

Who can afford to retire if real returns are at 2.5%? I've done the math for me and it wouldn't be the end of the world but it would be a *much* different type of retirement.
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Re: what low real rates mean for stock returns

Post by EDN »

kermit wrote:I'm 27 years old and maintain a 60/40 ratio. Vanguard says this returns on average 8.6%: https://personal.vanguard.com/us/insigh ... llocations. Even with modest inflation this isn't nearing the 2.5% real some of you are throwing around for similar portfolios.

Who can afford to retire if real returns are at 2.5%? I've done the math for me and it wouldn't be the end of the world but it would be a *much* different type of retirement.
Just curious,

As a 27 year old, how did you arrive at 40% in bonds?

Eric
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Re: what low real rates mean for stock returns

Post by kermit »

EDN wrote:
kermit wrote:I'm 27 years old and maintain a 60/40 ratio. Vanguard says this returns on average 8.6%: https://personal.vanguard.com/us/insigh ... llocations. Even with modest inflation this isn't nearing the 2.5% real some of you are throwing around for similar portfolios.

Who can afford to retire if real returns are at 2.5%? I've done the math for me and it wouldn't be the end of the world but it would be a *much* different type of retirement.
Just curious,

As a 27 year old, how did you arrive at 40% in bonds?

Eric
I've been through 2 windfalls (an acquisition and an IPO) and no longer need to take much risk. In short: I worked hard and got lucky.
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Artsdoctor
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Re: what low real rates mean for stock returns

Post by Artsdoctor »

Kermit: That Vanguard link that you posted gives you past returns and says nothing about anticipated future real rate of returns. Of course no one has a crystal ball and you have to do the best you can with what you're given. If you take a look at that Vanguard site, the 100% bond portfolio nominal return (not real) from 1926-2011 was 5.6%. Perhaps that might translate to a 3% REAL return for bonds in retrospect.

At least for me, I cannot factor a real rate of return from bonds alone going forward at 3% unless I'm investing while looking in the rearview mirror. I could be pleasantly surprised, though.

Artsdoctor
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Re: what low real rates mean for stock returns

Post by wesleymouch »

If real returns of stocks are 4-5% and real returns on bonds/cash are essentially 0-1% then why would a 2.5% withdrawal rate not be able to be sustained in perpetuity assuming a 50%/50% stock/bond split?
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Re: what low real rates mean for stock returns

Post by azanon »

Long-term portfolio estimates such as 2% real are absolutely insane. I can't believe you guys are not shredding this.

First of all, the US market is about the priciest one out there. Who is just investing US??? Valuations overseas are not even at median levels, and I'm talking P/E 10s. This is a bit dated, but look at this chart that Melbane Faber sometimes does ( http://www.mebanefaber.com/2012/11/08/b ... e-streets/ ). That's not surprising right? The European crisis, Japan has been in a 20+ year bear market, Emerging Market is still fairly priced. Bottom line, if you got 50/50 US vs. Foreign, or 1/3rd, 2/3rd like I do, then that pretty much tosses the overpriced US market right out the window.

As for bonds, I'd say take the Wbern approach, and just use mainly short term treasury, forget yield, and think of them as a riskless asset proxy or cash proxy. They have two purposes, lowering volatility, and are also used to rebalance your portfolio. I'd have to completely lose my mind to go higher on maturity and/or duration given the bottomed-out interest rates.

I use 7.5% nominal when I estimate, and I consider that conservative, with an 80/20 Equity, 2/3rd foreign stock, minus 15 basis points for Vanguard Admiral Index fees, minus 3% inflation (which is really a high estimate). So, 4.35% real, conservative. That nonsense W Pfau had in that article about compounded vs. arithmetric returns should be completely disregarded. He used examples that said nothing about dividend yields. There are a lot of people out there completely forgetting about dividends, such as when they're talking about the major indexes approaching their all-time high. They already hit the all-time high, if you count dividend reinvestment!
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Re: what low real rates mean for stock returns

Post by Artsdoctor »

We might be getting somewhat off-track here. Larry's original column essentially pointed out that there is a decent argument to be had for a muted return in investments over the next decade. The concept of Risk-Free Investment (short-term treasuries) plus Equity Premium equals an Equity Return is interesting and in this particular interest rate environment, might serve as a warning to anyone anticipating historical returns repeating themselves over the next decade. Beyond that decade, who knows? If you're 27, you might well expect everything to "revert to the mean" because you have many decades ahead of you. If you're 55 or more, the hypothesis might give you pause. We're all going to have to deal with the fact that real return of fixed income is just going to be extremely low (or negative) for a while. You can reach for yield, extend your maturity, buy junk, but then you have to ask yourself if you really understand what you want from your fixed income part of the portfolio.

You could very well be happy with an 80/20 stock/bond portfolio. I'm in my 50s and I just cant' do that. And my colleagues that were my age in 2008 and who were invested heavily in equities paid a very dear price. I'm anticipating a 0-1% real return in fixed income for the next decade but that's because I don't take risk on the FI side. I'm really hoping for a 8% real return from my stock side! But there's no way I'm going to count on it.

I'm assuming everyone counting on a high equity return with stocks is aware of Vanguard's performance data including re-investment of dividends: the Total Market Admiral Index average annual return (nominal) from inception to present (11/13/2000 to 2/28/2013) was 3.76%, the Total International Stock Market Index annual return from inception to present (4/29/1996 to 2/28/2013) was (a nominal) 4.65%. You can cherry-pick any period you'd like but a random block like those certainly didn't reward equity investors handsomely.

It's a very tough environment out there for fixed income. The original article simply linked the ridiculously low fixed income returns to equity returns in an intriguing way. You can ignore it, or not.
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Re: what low real rates mean for stock returns

Post by azanon »

Artsdoctor wrote:You could very well be happy with an 80/20 stock/bond portfolio. I'm in my 50s and I just cant' do that. And my colleagues that were my age in 2008 and who were invested heavily in equities paid a very dear price. I'm anticipating a 0-1% real return in fixed income for the next decade but that's because I don't take risk on the FI side. I'm really hoping for a 8% real return from my stock side! But there's no way I'm going to count on it.
You just choose not to do that. You certainly could do that, and not have much difficulty justifying it if you were to take the viewpoint that your investment time horizon is approximately 30 years (I'm assuming you'll live to your 80s on average, which should be conservative using an actuary table at your current age). I believe even Mr. Ferri uses an 80/20 and if he's not 50, he's gotta be getting close.

And did those who were 80/20 in 2008 really pay dearly? Perhaps so if they sold in 2008. If they didn't, I trust that someone who maintained their 80/20 has completely recovered, probably with change on top of that. The baseline requirements for any allocation is that you don't sell when times get rough.
I'm assuming everyone counting on a high equity return with stocks is aware of Vanguard's performance data including re-investment of dividends: the Total Market Admiral Index average annual return (nominal) from inception to present (11/13/2000 to 2/28/2013) was 3.76%, the Total International Stock Market Index annual return from inception to present (4/29/1996 to 2/28/2013) was (a nominal) 4.65%. You can cherry-pick any period you'd like but a random block like those certainly didn't reward equity investors handsomely.
Like you said, if you're going to allow me to "cherry-pick" a time to prove stocks have great returns using a ~ 13 to 16 year period, I'm sure I could find a period that would sound quite a bit better than 3.76 or 4.65% nominal. But we seem to agree that the usefulness of doing so is not of great value so I'll refrain. But, back to time horizons, mine is about 40 years so if we want to do this for fun, what's the worst 40 year nominal returns you can find for total international or total us stock market?

My essential point is simply this; for a 30 year+ time horizon, 2% real as an estimate is ridiculous for previous reasons stated. If your time horizon really is 13 years or less, then maybe that is a bit closer to being correct because person in their mid-70s probably shouldn't own that much stock. But I'd strongly consider you to not think of your time horizon as ending once you retire. I'm going to assume (safely?) that you have no intention of selling all of your stock upon retirement. Surely Dr. Pfau's suggestion to load up on annuities during retirement only represents a very small portion of bogleheads.
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Re: what low real rates mean for stock returns

Post by Mitchell777 »

This is a very personal decision because no one knows what the future holds. If you feel you can get 5% to 8% real with 50/50, plan accordingly. If you are only comfortable with 2%, plan accordingly. I do know from experience that there is a significant change in the way most people see things, age 25 vs 55, regardless of how many more years the 55 year old thinks they may live. I think 2% is a bit low for planning purposes. I am using a Floor of ~ 2.5% but I do not know what the future holds, nor does anyone else. There was a post very recently that showed there have been 3 or 4 decades in a row where bonds returned ~0% real each decade. That is a concern if you are 55. Now maybe stocks will return 6 or 8% of that time frame and all will be well, or maybe not. Or you may find your risk tolerance changes when you are 70+ years old and 50/50 makes you nervous. This is an issue about what you feel comfortable with. Are there real return estimates that most could agree are ridiculous? Sure, but I do not believe 2% is in that camp although I do believe it will be a floor
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Re: what low real rates mean for stock returns

Post by Artsdoctor »

I think that's fair. I'm not implying that I believe a 2-2.5% real return will be the most accurate return going forward for a 50/50 portfolio. What I'm saying is that I'm planning for it. I actually don't believe my house is going to be destroyed by an earthquake (I live in Los Angeles); but I have earthquake insurance.

Because of this board, I truly did ride through the 2008 meltdown and, frankly, ultimately profited from it. But it was really only because of this board and the major contributors that more or less held my hand. The VAST majority of investors in this country caved in one way or another. They may not have sold everything but they truly suffered. Let me assure you: a 60-year-old with an 80/20 split and no other retirement income anticipated is NOT going to sleep well at night when the market tanks over 50%. Even if the courageous investor rode it through, I guarantee that lifestyle decisions would be different, at least temporarily (don't sell your practice, send your kid to a state school, forgo graduate education, or worse).

A 50/50 split for me is comfortable because I've lived through an amazing run of both equity and bond bull markets (1980s onward, despite the bears), and I've not waivered from my IPS in over a decade. I don't need to take the risk. It's just that I feel a lot of people are making assumptions that are based on past data; I KNOW pension plans are and look at that disaster!

And the idea of the original article initially was looking forward to the next decade, not the next century. Of course I'm planning for the next 30 years of investing but I'm DEFINITELY not anticipating an 80/20 split in retirement! I have major decisions to make regarding work within the next 2-3 years; I would much rather be conservative in my portfolio estimates than invest with rose-colored glasses. The risk is just too high.
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Re: what low real rates mean for stock returns

Post by azanon »

Artsdoctor wrote:And the idea of the original article initially was looking forward to the next decade, not the next century. Of course I'm planning for the next 30 years of investing but I'm DEFINITELY not anticipating an 80/20 split in retirement! I have major decisions to make regarding work within the next 2-3 years; I would much rather be conservative in my portfolio estimates than invest with rose-colored glasses. The risk is just too high.
To be clear, I wouldn't recommend an 80/20 in full-blown retirement either if one didn't have another form of passive income (like a pension). However, my point on time horizons, is to say be aware that when you see recommendations for stock allocation and they ask you what your time horizon is, that the presumption is that you need all of the money at the end of that time horizon. Does that make sense? For instance, if you're saving for a car, and you plan to buy one with cash 5 years from now, that's your time horizon. However, if you're going to go from an 80/20 to, lets say, a 40/60 when you retire 10 years from now, your time horizon isn't 10 years because you're still going to keep half of your stock. Exactly what would it be, is a mathematical debate, but it's more than a straight-up 10 years like a savings goal.

The other item that deserve a lot of extra attention is an assumption of building in an automatic 3% inflation deduction. There are plenty of great articles that discuss the real impact of inflation on a savy consumer. Anyone fans of Mister Money Moustache? I believe he wrote an article on what I'm about to quickly summarize but it amounts to this: If the average inflation rate is 3%, it's not 3% for everything. Some things it's more, others it is less. Also, if you're willing to not advance in technology with everyone else and be content where you are, inflation is generally 0%. Since you have a choice in what you buy, or don't buy, you can simply choose not to buy the expensive luxuries that match or greatly exceed inflation. The short summary is that you're not going to necessarily be a victim of a 3% inflation rate if that's what it is on average. Simply exercising discretion in what you buy can take out half of that.

I guess it comes down to preference with estimating growth rates, but I typically use a conservative estimate instead of a worst-case floor. IMHO with my portfolio as previously stated, I'm estimating 4.35% real, and I consider that conservative.
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Re: what low real rates mean for stock returns

Post by Artsdoctor »

Of course, inflation means different things to different people.

This is the strength of the forum. People offering different opinions and different ways of looking at things. Larry's article may or may not be accurate. To dismiss it out of hand, IMHO, would be a missed opportunity. Plan A might be to anticipate 5-6% real return, which is perfectly fine. But the one thing that I've found is that you really need a Plan B (and usually a Plan C).

We are a two-physician household. Our days are filled, everyday, with patients who wake up in the morning expecting to have a perfectly reasonable day. And then they discover a lump, have chest pain, get short of breath, see a mole that doesn't look quite right. It just happens, and it happens to us all somehow and sometime. You just have to be flexible. Have a contingency plan if your original plan just doesn't pan out.

Larry's article is provocative. Just give it some thought.
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Re: what low real rates mean for stock returns

Post by azanon »

Artsdoctor wrote:This is the strength of the forum. People offering different opinions and different ways of looking at things. Larry's article may or may not be accurate. To dismiss it out of hand, IMHO, would be a missed opportunity. Plan A might be to anticipate 5-6% real return, which is perfectly fine. But the one thing that I've found is that you really need a Plan B (and usually a Plan C).
I am a huge fan of Larry's work. I don't dismiss his article, rather am simply comforted by the fact that I'm not bound to investing in the overpriced, and low-interest rate U.S. market. You may or may not be aware that Larry actually advocates investing as much as half of one's equity positions in foreign markets. He could have mentioned that solution in that article but it would have taken away a lot of the punch and fear factor.
We are a two-physician household. Our days are filled, everyday, with patients who wake up in the morning expecting to have a perfectly reasonable day. And then they discover a lump, have chest pain, get short of breath, see a mole that doesn't look quite right. It just happens, and it happens to us all somehow and sometime. You just have to be flexible. Have a contingency plan if your original plan just doesn't pan out.
My contingency is that I can always make more money. Someone beat me to the punch when they said it was amongst the most easily renewable resources there is. I'm particularly skilled at two specific jobs; The one I have now, and the job of finding a new one should the need arise. My other major contingency is my willingness to live a low cost of living lifestyle, which I already do.
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