Where expected returns are highest, and should you go there

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Maynard F. Speer
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Re: Where expected returns are highest, and should you go there

Post by Maynard F. Speer » Mon Nov 16, 2015 8:35 pm

I always find it interesting to compare my asset allocation to the endowment portfolios (for my money, about as academic and considered as portfolio management gets)

Here's Princeton's target allocations for 2015 (spot the mistake with the graphic btw)

Image

So you see a not-too-heavy bet on US equities, at 9% .. Reasonable exposure to International at 6% .. Emerging Markets at 10%, reflecting potentially better long-term opportunities, and the likelihood that risk is quite well priced into these markets

The other big driver of returns is private equity (if it's like Yale's it's perhaps split 2:1 between US and international) - where you've got a combination of lower valuations, higher risk, and potentially higher returns ... But across these portfolios, there's usually a strong tilt towards value and smaller companies
"Economics is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions." - John Maynard Keynes

small_index
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Re: Where expected returns are highest, and should you go there

Post by small_index » Mon Nov 16, 2015 10:49 pm

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lack_ey
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Re: Where expected returns are highest, and should you go there

Post by lack_ey » Mon Nov 16, 2015 11:02 pm

I wouldn't use historical US CAPE vs. future returns as any real guide to what returns we might see in EM based on current CAPE. CAPE in one country is not really directly applicable to CAPE in another, and historical values are of limited applicability to the future as well. There are just way too many things that are different in the comparison proposed.

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Re: Where expected returns are highest, and should you go there

Post by rkhusky » Tue Nov 17, 2015 8:11 am

lack_ey wrote:
rkhusky wrote: Probably because the data is too noisy to produce anything other than a linear prediction. One would need better data to include nonlinear components to the prediction. Interesting that the uncertainty would decrease with time. It seems like I remember a post saying that dispersion increases the further out you look.
I think this is a matter of interpreting confidence and dispersion, whether results are compounded or annualized.

Let's say our forecast is 3.8% real. In ten years, we get 1.7% real. In twenty years, it's actually been 2.5% real over all twenty years. Both would actually be fairly accurate—this stuff can be more wrong over any given period.

1.7% over 10 years is 18.36% cumulative compared to the forecast of 45.20% cumulative. The ending value is 81.5% of the forecast after ten years. 2.5% over 20 years is 63.86% cumulative compared to the forecast of 110.84%. The ending value is 77.7% of the forecast after twenty years.

Which do you call closer? Which had higher dispersion? 2.5% is closer than 1.7% is to the forecast. But we are further off the expected target in terms of total return after twenty years in dollar amounts or by most accountings.

Note that between our forecast now and dates ten and twenty years later, we can keep updating and generating new forecasts that may be more accurate because they contain the now-current state. That doesn't make the current forecast based on best available information now any more or less correct.
I was thinking that if one did a Monte Carlo simulation for future returns, perhaps one would find that indeed there is wider dispersion of potential results the further one went out in time, but that the probability for those outcomes that were far from the mean decreased sufficiently, such that the dispersion of the average return remained constant or even decreased over time. Just a conjecture.

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Re: Where expected returns are highest, and should you go there

Post by larryswedroe » Tue Nov 17, 2015 8:36 am

rhusky
The further you go out the wider the potential dispersion of TOTAL returns goes, but that's not true for annualized returns. And when we speak about expected returns we talk about annualized returns

Small Index
10.8 to 11.9 real return averaged 10.4
11.9-13.8 averaged 9.1
13.8-15.7 averaged 8.0

Note the monotonic relationship which shows it's pretty obvious that valuations predict (have information) future returns, though there is a lot of noise in the data because risk premiums change --which is why valuations only explain about 40% of returns
Larry

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Re: Where expected returns are highest, and should you go there

Post by azanon » Tue Nov 17, 2015 9:13 am

HomerJ wrote:
azanon wrote:Finally, why would you intentionally go through 10-bad years, if you had an indicator with reasonable reliability that would prevent you from having to do so?
Because we do not have an indicator with reasonable reliability.

People have been predicting poor 10-year stock returns based on CAPE10 since 1992. How many ten-year periods does it have to fail before people stop referencing it? In the past thirteen 10-year periods (1992-2002, 1993-2003,...2005-2015), how many times have returns actually been low?
S&P 500's performance has been poor for quite a long time. Head over to morningstar and feel free to confirm, that the S&P 500 has returned 4.76% (nominal) for the past 15 years. CAPE was high during that period, and there's your poor return.
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Re: Where expected returns are highest, and should you go there

Post by azanon » Tue Nov 17, 2015 9:15 am

rkhusky wrote:
azanon wrote: I know someone who does this for US S&P500 using CAPE. Rob Bennett has a nifty little calculator (which I have no idea how accurate it is) at his website, using CAPE for US stock, for a given timeframe. I went to his website just now, and its showing, 1.31% real prediction (for S&P 500 for next 10-yr), with best possible at 7.31% real, and worst possible at -4.69% real (that's the 5% to 95% range - 2 Standard Deviations I believe?). Again, I think this is strictly CAPE based though.
Just a quibble, but that should really be 1% +- 6%. Can't have that many significant figures when the uncertainty is so large.
... with Rob Bennett. I'm just the mail carrier.

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Re: Where expected returns are highest, and should you go there

Post by azanon » Tue Nov 17, 2015 9:19 am

HomerJ wrote:
azanon wrote:
rkhusky wrote:Perhaps for every expected return that is published, one should also include the error bars, e.g. 4% +- 12%.
I know someone who does this for US S&P500 using CAPE. Rob Bennett has a nifty little calculator (which I have no idea how accurate it is) at his website, using CAPE for US stock, for a given timeframe. I went to his website just now, and its showing, 1.31% real prediction (for S&P 500 for next 10-yr), with best possible at 7.31% real, and worst possible at -4.69% real (that's the 5% to 95% range - 2 Standard Deviations I believe?). Again, I think this is strictly CAPE based though.
Two standard deviations only works if returns follow a normal distribution, right?
If one could simulate 1000s of possible outcomes, I'd have no reason to suspect the results wouldn't end up being normally distributed. It's an estimate with an error range, and I'm not aware of any factor that would cause the outcomes to be skewed repeatidly.

I'm 22 years removed from stats class though.

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Re: Where expected returns are highest, and should you go there

Post by small_index » Tue Nov 17, 2015 12:53 pm

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Re: Where expected returns are highest, and should you go there

Post by HomerJ » Tue Nov 17, 2015 1:40 pm

azanon wrote:
HomerJ wrote:
azanon wrote:Finally, why would you intentionally go through 10-bad years, if you had an indicator with reasonable reliability that would prevent you from having to do so?
Because we do not have an indicator with reasonable reliability.

People have been predicting poor 10-year stock returns based on CAPE10 since 1992. How many ten-year periods does it have to fail before people stop referencing it? In the past thirteen 10-year periods (1992-2002, 1993-2003,...2005-2015), how many times have returns actually been low?
S&P 500's performance has been poor for quite a long time. Head over to morningstar and feel free to confirm, that the S&P 500 has returned 4.76% (nominal) for the past 15 years. CAPE was high during that period, and there's your poor return.
Oh, did you invest ALL your money in the S&P 500 at the very peak of the dot-com bubble? And not a penny since?

Or did you also invest some money in November 1992, 1996, 2004, 2008, etc.?

Year, CAPE10, return to today
1992, 20, ~9% a year
1996, 25, ~8% a year
2000, 44, ~5% a year
2004, 27, ~7% a year
2008, 20, ~16% a year

CAPE10 has been above 20 for nearly 23 straight years (it did drop briefly back to 15 in 2009)... In all that time, buying and holding still gave a decent return...

Heck, even buying at the highest CAPE10 in U.S. history (44 in 2000) still returned 4.76% nominal over the past 15 years. Thank you for proving my point!

We have people here worried that the current CAPE10 of 21 means dark times are ahead, and we better "expect" super low stock returns going forward, completely discounting that we've been at CAPE10 of 20 or higher for nearly 23 years straight, without seeing super low stock returns.

At what point will economists revise their CAPE10 predictions? There are just so many variables in economics. I feel for the people who spend their lives trying to make sense of it all. Is all economic data from 1940 still relevant today? Or maybe just some of it?

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Re: Where expected returns are highest, and should you go there

Post by azanon » Tue Nov 17, 2015 1:49 pm

small_index wrote:
azanon wrote:
HomerJ wrote:Two standard deviations only works if returns follow a normal distribution, right?
If one could simulate 1000s of possible outcomes, I'd have no reason to suspect the results wouldn't end up being normally distributed. It's an estimate with an error range, and I'm not aware of any factor that would cause the outcomes to be skewed repeatidly.

I'm 22 years removed from stats class though.
A key point in "Black Swans" is the lack of normal distribution near the edges.
https://www.bogleheads.org/wiki/Excess_kurtosis
If by edges, you mean beyond 2SD, then what bearing does that on the meaning of results falling within 2SD? I would think zero. I was giving ranges for 2SD max.

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Re: Where expected returns are highest, and should you go there

Post by azanon » Tue Nov 17, 2015 2:12 pm

Homer,

>My general point was CAPE has been high for most of the past 15 years, and consistent with CAPE research, the returns have been very poor relative to S&P 500 history. So what if it was the PEAK at the start, all that's at stake is asking did CAPE work, and I would say it did. It wasn't a 12% Dave Ramsey return, it was 1/3rd of that, or thereabouts. 4.76% nominal for 100% equities, with their associated risks, is nothing short of miserable. It fully supports my point, and I believe draws into question anyone who would say that wasn't an example where CAPE appeared to work.

> Current US CAPE is 26, not 21. If it was 21, I wouldn't even be posting right now, most likely. 21 would be elevated, but not red zone high. As for dark times ahead, don't take my word for it. I'm just a biologist. How about Jack Bogle. Find his latest video at morningstar and get back to me on what you think about his outlook for the markets. If you want a preview, it's a lot closer to the outlook I'm giving than yours. And as I understand it, Larry's working on a piece that will say something similar. Heck, everyone's getting in line to say this.

> The point where CAPE predictions will be revised, is when the data for CAPE finally starts to break down. You like to point out the US stock 90s performance outlier, as do most CAPE opponents. If you want to take that approach, let me help you. And even better find is Japan stock market, pre 1989, where their CAPE went over 100 I believe at their peak. Of course be sure to leave out the ensuing 20 year+ bear market that followed.

>It's been mentioned already, but one should be careful to not make the mistake of finding an outlier example, then using that example to claim that a general rule of thumb is invalid. Also, just because a certain outcome happens to differ from a sound strategy, it doesn't invalidate the strategy. Outcomes don't prove who's right or wrong. This is a game of probabilities. But the cruel reality is, that even a broken clock is right twice a day.

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Re: Where expected returns are highest, and should you go there

Post by HomerJ » Tue Nov 17, 2015 4:33 pm

azanon wrote:Homer,

>My general point was CAPE has been high for most of the past 15 years, and consistent with CAPE research, the returns have been very poor relative to S&P 500 history. So what if it was the PEAK at the start, all that's at stake is asking did CAPE work, and I would say it did. It wasn't a 12% Dave Ramsey return, it was 1/3rd of that, or thereabouts. 4.76% nominal for 100% equities, with their associated risks, is nothing short of miserable. It fully supports my point, and I believe draws into question anyone who would say that wasn't an example where CAPE appeared to work.

> The point where CAPE predictions will be revised, is when the data for CAPE finally starts to break down. You like to point out the US stock 90s performance outlier, as do most CAPE opponents.

You are the one using an outlier to prove a point... CAPE has been in 20s for 22 of the past 23 years. That's 13 different 10-year periods. In one of those periods (2000) the following 10-year returns were low...

But still positive!

The other twelve 10-year time-periods with CAPE above 20, the returns have been decent... 7%, 8% range... lower than the historical average, but not as low as predicted.
When the CAPE 10 was between 21.1 and 25.1, the 10-year forward real return averaged just 0.9 percent.
We've been far above that return for the past 23 years. Not just a few years in the 90s, for the past 23 years. Even 2000, when the CAPE10 was 44, we've gotten a better return than that "expected" return above.

Using CAPE10 data from the past 100 years hasn't done a very good job predicting the past 23 years. That's all I'm saying... So why should I believe its predictions for the next 10 years?
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Re: Where expected returns are highest, and should you go there

Post by HomerJ » Tue Nov 17, 2015 4:39 pm

larryswedroe wrote:Homer
EXACTLY
When economists use the term EXPECTED returns it's called an UNCONDITIONAL forecast, it's not conditioned on the time frame.
Obviously after time passes the forecast BEGINNING in time T+1 will change-- it will increase if the returns are BELOW the original forecast (assuming valuations went down) and decrease if the returns are ABOVE the original forecast (assuming valuations went up)

Larry
I'm still confused, sorry... Why do economists make 10-year predictions then?
When the CAPE 10 was below 9.6, 10-year forward real returns averaged 10.3 percent. In relative terms, that is more than 50 percent above the historical average of 6.8 percent (9.8 percent nominal return less 3.0 percent inflation). The best 10-year real return was 17.5 percent. The worst was still a pretty good 4.8 percent real return, just 2.0 percent below the average, and 29 percent below it in relative terms. The range between the best and worst outcomes was a 12.7 percent difference in real returns.
• When the CAPE 10 was between 15.7 and 17.3 (about its average of 16.5), the 10-year forward real return averaged 5.6 percent. The best and worst 10-year forward returns were 15.1 percent and 2.3 percent, respectively. The range between the best and worst outcomes was a 12.8 percent difference in real returns.
• When the CAPE 10 was between 21.1 and 25.1, the 10-year forward real return averaged just 0.9 percent. The best 10-year forward real return was still 8.3 percent, above the historical average of 6.8. However, the worst 10-year forward real return was now -4.4 percent. The range between the best and worst outcomes was a difference of 12.7 percent in real terms.
• When the CAPE 10 was above 25.1, the real return over the following 10 years averaged just 0.5 percent
You are not saying that the actual 1-year returns or 5-year returns or 20-year returns were identical to the 10-year returns shown above, correct?

That's why I'm asking about the time-frame for "expected" returns.

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Re: Where expected returns are highest, and should you go there

Post by larryswedroe » Tue Nov 17, 2015 4:49 pm

Homer
They use 10 years as a "long term" forecast. have to use some period. But they would make the same for 5 years or 20 years. REason is simple, they make assumption of new change in valuations (even though they know this will not likely be true--but it's not forecastable, it's what Bogle called the speculative return)

Second question your assumption is correct, the other period returns were not identical, of course not as the speculative returns were different.

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Re: Where expected returns are highest, and should you go there

Post by small_index » Tue Nov 17, 2015 11:31 pm

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Re: Where expected returns are highest, and should you go there

Post by azanon » Wed Nov 18, 2015 8:37 am

small_index wrote:Main point is that the market won't follow a standard distribution. But to answer that specific point, the area within 2SD might be flatter than you expect owing to the bulge of results outside 2SD.
That's all fair enough. Perhaps Rob Bennett was breaking the statistical rules a little bit giving those "ranges", but I don't know the formula he was using. But there's no way I'm going to ask him, and I'll leave that, at that. :shock:

...

Homer - read your response, and I have no additional comment. I made the point(s) i wanted to make here, and have no further comment.

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Re: Where expected returns are highest, and should you go there

Post by rkhusky » Wed Nov 18, 2015 12:11 pm

larryswedroe wrote:Homer
They use 10 years as a "long term" forecast. have to use some period. But they would make the same for 5 years or 20 years. REason is simple, they make assumption of new change in valuations (even though they know this will not likely be true--but it's not forecastable, it's what Bogle called the speculative return)

Second question your assumption is correct, the other period returns were not identical, of course not as the speculative returns were different.
One could use CAPE 5 to predict 1-year, 5-year, 10-year, 20-year returns. Or one could use CAPE 1, CAPE 10 or CAPE 20. The math would be the same. I suspect that CAPE 10 predicting 10 year returns has the least error (or predicts the largest portion of the return, 40% I believe I saw quoted), which is why it is used.

Since one has a yearly sequence of 10 year predictions and if all the predictions are equally valid, then it should be possible to predict the trend of returns over the next 10 years.

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Re: Where expected returns are highest, and should you go there

Post by Maynard F. Speer » Wed Nov 18, 2015 1:26 pm

rkhusky wrote:
larryswedroe wrote:Homer
They use 10 years as a "long term" forecast. have to use some period. But they would make the same for 5 years or 20 years. REason is simple, they make assumption of new change in valuations (even though they know this will not likely be true--but it's not forecastable, it's what Bogle called the speculative return)

Second question your assumption is correct, the other period returns were not identical, of course not as the speculative returns were different.
One could use CAPE 5 to predict 1-year, 5-year, 10-year, 20-year returns. Or one could use CAPE 1, CAPE 10 or CAPE 20. The math would be the same. I suspect that CAPE 10 predicting 10 year returns has the least error (or predicts the largest portion of the return, 40% I believe I saw quoted), which is why it is used.

Since one has a yearly sequence of 10 year predictions and if all the predictions are equally valid, then it should be possible to predict the trend of returns over the next 10 years.
For nominal returns the correlation's strongest around 10 years .. But for real returns you're really looking between 15 and 20 years, where it gets close to a 0.7 correlation

Interesting to note the correlation at 10 years is only slightly higher than at 30 .. So what's cheap today could really have quite a significant effect on your whole investing career

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Re: Where expected returns are highest, and should you go there

Post by HomerJ » Wed Nov 18, 2015 1:45 pm

Maynard F. Speer wrote:Interesting to note the correlation at 10 years is only slightly higher than at 30 .. So what's cheap today could really have quite a significant effect on your whole investing career
Assuming that CAPE10 for the U.S. past 100 year history has any bearing at all on other countries going forward returns.

I see people looking at Emerging Markets or for instance, Russia, and saying, "wow, look how cheap! In the past, CAPEs that low really paid off!"

Except that they paid off in the U.S. past. Is it the same? Do we have 100-year studies on historical CAPE for Russia? Or Vietnam? I don't think so.

Heck, I don't even think the past U.S. history even applies to the present U.S. anymore, what with accounting changes, stock buy-backs, etc.

Either the U.S. is due for a HUGE extended crash to bring CAPE average back to historical levels, or the historical levels are no longer relevant.

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Re: Where expected returns are highest, and should you go there

Post by larryswedroe » Wed Nov 18, 2015 2:24 pm

Homer
Low valuations show high EXPECTED return as compensation for HIGH RISK. So the risks can show up and you get low returns

On other hand high valuations at BEST basically forecast low expected returns (unless valuations rise further), and if valuations fall returns will be worse

Larry

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Re: Where expected returns are highest, and should you go there

Post by larryswedroe » Wed Nov 18, 2015 2:38 pm

Homer
Low valuations show high EXPECTED return as compensation for HIGH RISK. If risks are as expected you get high returns. But the risks can show up and you get low returns. On other hand if things turn out better than expected valuations rise and you really get high returns.

On other hand high valuations at BEST basically forecast low expected returns (unless valuations rise further), and if valuations fall returns will be even worse

Larry

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Re: Where expected returns are highest, and should you go there

Post by Maynard F. Speer » Wed Nov 18, 2015 8:41 pm

HomerJ wrote:
Maynard F. Speer wrote:Interesting to note the correlation at 10 years is only slightly higher than at 30 .. So what's cheap today could really have quite a significant effect on your whole investing career
Assuming that CAPE10 for the U.S. past 100 year history has any bearing at all on other countries going forward returns.

I see people looking at Emerging Markets or for instance, Russia, and saying, "wow, look how cheap! In the past, CAPEs that low really paid off!"

Except that they paid off in the U.S. past. Is it the same? Do we have 100-year studies on historical CAPE for Russia? Or Vietnam? I don't think so.

Heck, I don't even think the past U.S. history even applies to the present U.S. anymore, what with accounting changes, stock buy-backs, etc.

Either the U.S. is due for a HUGE extended crash to bring CAPE average back to historical levels, or the historical levels are no longer relevant.
Absolutely, CAPE can't tell you anything about secular shifts - can't tell you much about Russia in 20-30 years ... Maybe it'll look indistinguishable from N.America; maybe it'll be ring-fenced and full of work camps like N.Korea

But what valuation does give you is a trend - and when you've identified a trend, and it seems to fit out-of-sample (e.g. now we're applying it to global markets), and when there are reasonable behavioural and financial explanations for it, then at some point you've got to decide whether the burden of proof in on demonstrating that it will keep working, or that it won't

In a global economy - if you strip away today's political risks - it doesn't make much sense to me that the world will go on paying 4x as much to own a like-for-like energy firm in the US, vs one in Russia (especially when the Russian firms are paying 7% dividends) ... But that doesn't tell you whether political risk will be better or worse in the future ... So as with any trend, you play the averages - much like when you decide your stock/bond allocation

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Re: Where expected returns are highest, and should you go there

Post by HomerJ » Thu Nov 19, 2015 3:28 pm

Maynard F. Speer wrote:In a global economy - if you strip away today's political risks - it doesn't make much sense to me that the world will go on paying 4x as much to own a like-for-like energy firm in the US, vs one in Russia (especially when the Russian firms are paying 7% dividends)
Because you can't strip away today's political risks, it makes total sense to me.

Which is why low CAPE values in Russia may indeed be a worthless indicator. Or maybe not.

I'm not gambling with my life savings any more than I have to. I don't need to make a killing to achieve my goals. There are a lot more variables out there than valuations.

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Re: Where expected returns are highest, and should you go there

Post by Maynard F. Speer » Thu Nov 19, 2015 9:13 pm

HomerJ wrote:
Maynard F. Speer wrote:In a global economy - if you strip away today's political risks - it doesn't make much sense to me that the world will go on paying 4x as much to own a like-for-like energy firm in the US, vs one in Russia (especially when the Russian firms are paying 7% dividends)
Because you can't strip away today's political risks, it makes total sense to me.

Which is why low CAPE values in Russia may indeed be a worthless indicator. Or maybe not.

I'm not gambling with my life savings any more than I have to. I don't need to make a killing to achieve my goals. There are a lot more variables out there than valuations.
There are many indicators, but valuation tends to be one of the more reliable

Obviously investing in Russia carries specific risks, however investing in any major economy on high valuations (e.g. 90th percentile) has tended to carry its own risks ... Such as the risk of finding yourself in a painful bear market (Japan 1990), or of not being well compensated for the risk of having your money in the market

If as Asness points out, having stocks and bonds in the 90th percentile is both unprecedented and likely to lead to disappointing long-term returns (at least historically), a small allocation to higher risk investments - or a tilt towards lower valuations - may be prudent
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Re: Where expected returns are highest, and should you go there

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