Part 2 of the perfect storm post, how to increase EXPECTED returns

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Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by larryswedroe » Mon Dec 21, 2015 8:39 am

http://www.etf.com/sections/index-inves ... nopaging=1

Offering several options investors should CONSIDER

Hope you find it helpful
Larry

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by White Coat Investor » Mon Dec 21, 2015 9:16 am

I find your solution to the problem incomplete as I've written here:

http://whitecoatinvestor.com/making-dif ... d-returns/

If you really expect these terribly low returns, that completely changes the game. All kinds of other things to do with your money- like buying investing properties now look more attractive. I was also surprised to see you didn't mention taking more small and value risk in addition to more equity risk.

But 2% real means your money only doubles once in 3-4 decades. If I really believed that, I'd be walking around my neighborhood buying every property that came up for sale, paying cash for it, and enjoying my 4-6% real returns on completely paid for houses. It's not hard at all to find houses with cap rates of 4-6%. Real estate investors don't even look at those.
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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by Levett » Mon Dec 21, 2015 9:44 am

Buttonwood (in The Economist) has a different take:

http://tinyurl.com/ppcm467

Me, I incline to inertia.

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by cfs » Mon Dec 21, 2015 10:00 am

Thank you.

Thanks Larry for another good article. Thanks for the comments on (1) increasing equity, (2) avoiding tracking-error regret, (3) increasing international, (4) increasing emerging market. Numbers one, two and three already taking care of (small increase early this year), currently "thinking" about number four. Again, thank you.

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by DaufuskieNate » Mon Dec 21, 2015 12:09 pm

EmergDoc wrote:I was also surprised to see you didn't mention taking more small and value risk in addition to more equity risk.
This is Part 2 of a multi-part series. A quote from today's installment:

"Later this week, we’ll discuss some additional steps investors can take to increase their portfolio’s expected returns. We’ll also provide a warning about risk assets, as well as review two ways to use investment factors to your advantage."

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by larryswedroe » Mon Dec 21, 2015 12:25 pm

EmergencyDoc
Note that re investment properties, the yields on them are now at about record lows as well. Just look at dividend yield on REITS, about 3.8%. Now the real expected return than based on historical negative real growth in REIT earnings is less than 2% --so well below that for equities, even US.

Larry

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by garlandwhizzer » Mon Dec 21, 2015 12:51 pm

Excellent post, Larry. I agree with all of your suggestions to be considered. In fact I did all of them in modest degree at the beginning of 2015. Still waiting patiently for my payoff which has not come, in fact just the opposite. I continue to believe, however, as firmly as one reasonably can about the future (which is always uncertain) that at some point, the payoff will come.

I try but cannot convince myself of the optimistic case for US equities going forward, that over the next decade or so they will continue to outperform INTL and EM, or that intermediate term Treasuries will continue to outperform essentially everything else. My equity is currently US60/DM20/EM20 and I keep plenty of cash and high grade US intermediate term bonds as a portfolio anchor for equity storms. I suggest that those considering such portfolio changes should not make radical portfolio adjustments, betting the house on it, but rather adjust portfolios modestly in line with their risk tolerance and bearing in mind that even very well thought out and analyzed predictions of future returns may not materialize.

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by BlueEars » Mon Dec 21, 2015 12:58 pm

The S&P 500 has an expected return a full 4.5 percentage points higher than the five-year Treasury (specifically, the difference between a 4.2% expected return and a -0.3% expected return).
Question for Larry:

Right now the 5 year TIPS are at +0.42%. Why is the expected 5 year Treasury return -0.3% ?
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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by quantAndHold » Mon Dec 21, 2015 1:33 pm

EmergDoc wrote: But 2% real means your money only doubles once in 3-4 decades. If I really believed that, I'd be walking around my neighborhood buying every property that came up for sale, paying cash for it, and enjoying my 4-6% real returns on completely paid for houses. It's not hard at all to find houses with cap rates of 4-6%. Real estate investors don't even look at those.
That would be great, if the cap rates on everything in my local area weren't also at about 1-2%. In a lot of big cities there are a couple of well funded companies sweeping in and paying all cash for every house that would make a decent rental.

Sigh.

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by White Coat Investor » Mon Dec 21, 2015 1:39 pm

quantAndHold wrote:
EmergDoc wrote: But 2% real means your money only doubles once in 3-4 decades. If I really believed that, I'd be walking around my neighborhood buying every property that came up for sale, paying cash for it, and enjoying my 4-6% real returns on completely paid for houses. It's not hard at all to find houses with cap rates of 4-6%. Real estate investors don't even look at those.
That would be great, if the cap rates on everything in my local area weren't also at about 1-2%. In a lot of big cities there are a couple of well funded companies sweeping in and paying all cash for every house that would make a decent rental.

Sigh.
I guess my point is that I'm not sure people really believe equity returns will be so low because if they did, their money would flow elsewhere. Perhaps it already is as you've noticed in your area. But the point is that 2% real is a gamechanger. Even increasing it to 3% real is huge, and hopefully you can get that with a small/value/emerging tilt.
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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by Rx 4 investing » Mon Dec 21, 2015 1:44 pm

The rules of the investing game change as you get down to extremely low, zero or even negative, inflation (deflation) as we appear to be headed.

Peter Bernstein wrote many years ago if you squeeze all the inflation out of economy, return on risk assets collapses to zero. Without inflation, firms have very little pricing power, and have a very difficult time generating earnings.

From over 100 years of data from long duration treasury bond returns from all over the world, the 30 year bond (, not the 10 year) averaged 2.1% "real" return. The Fisher equation: Nominal yield minus inflationary expectations = real return

Over the last 12 months, the all items CPI increased 0.5 percent before seasonal adjustment.

http://www.bls.gov/news.release/cpi.nr0.htm

The 30 year yield closed on 12-18-15 at : 2.90%

https://www.treasury.gov/resource-cente ... data=yield

The approximate "real" return on a 30- year treasury = 2.9 % -0.5% = 2.4%. The "real" yield is running about 15% higher than historical average (+2.1%), providing evidence that 30 year treasury bonds are not in a "bubble" at the current price.

The "real" rate bounces all over the place in the short term, but we don’t need to worry about it because it is mean- reverting. When the inflation rate, and inflationary expectations are rock-bottom, with a chance of going to zero (or lower), a 2% “real “ return might be as good as we can get.

Think about it --In a zero inflation, deflationary world we get paid back in "harder" dollars (prices are falling). It may not be the way we are used to getting it, but it's still 2% real.

IMO: When considering the diminishing pricing power of firms in a low-flation or de-flationary environment, long duration treasuries have a probability of a better risk-adjusted "real" return.
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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by White Coat Investor » Mon Dec 21, 2015 1:50 pm

larryswedroe wrote:EmergencyDoc
Note that re investment properties, the yields on them are now at about record lows as well. Just look at dividend yield on REITS, about 3.8%. Now the real expected return than based on historical negative real growth in REIT earnings is less than 2% --so well below that for equities, even US.

Larry
I'm not sure I'd throw REITs into the same category as indvidiually owned and selected residential real estate. Very few REITS in that market- the properties are just too small time for these huge companies. Here's the first property I found in a quick search in my area:

http://www.zillow.com/homes/for_sale/UT ... ect/12_zm/

You get a duplex for $250K. It's basically two 1000 foot 2 bedroom apartments. You should be able to rent each of those for $850-900. So let's call that $1700 a month in rent. Multiply by 12 and then by 0.55 (~ 45% of rent will go toward non-mortgage expenses) and divide by $250k and you get a cap rate of 4.5. So, without leverage, and assuming the price of the house and the value of the asset keeps up with inflation, which I think is a very reasonable assumption, you've got an expected real return of 4.5%. Why would I take a portfolio with a real rate of 2% when these are lying around all over the place? I can buy this thing today, at asking price, and get 4.5%.

I'm just saying that's what I would do if I really thought my expected return were going to be 2% real on my portfolio.
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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by Geologist » Mon Dec 21, 2015 2:04 pm

BlueEars wrote:
The S&P 500 has an expected return a full 4.5 percentage points higher than the five-year Treasury (specifically, the difference between a 4.2% expected return and a -0.3% expected return).
Question for Larry:

Right now the 5 year TIPS are at +0.42%. Why is the expected 5 year Treasury return -0.3% ?
In his first entry in this series (see link), Swedroe has the nominal yield of 5 year Treasuries at 1.7% and the Federal Reserve Bank of Philadelphia's inflation forecast of 2%, therefore he gets a real return to the 5 year Treasury of -0.3%.

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by BlueEars » Mon Dec 21, 2015 2:18 pm

Geologist wrote:
BlueEars wrote:
The S&P 500 has an expected return a full 4.5 percentage points higher than the five-year Treasury (specifically, the difference between a 4.2% expected return and a -0.3% expected return).
Question for Larry:

Right now the 5 year TIPS are at +0.42%. Why is the expected 5 year Treasury return -0.3% ?
In his first entry in this series (see link), Swedroe has the nominal yield of 5 year Treasuries at 1.7% and the Federal Reserve Bank of Philadelphia's inflation forecast of 2%, therefore he gets a real return to the 5 year Treasury of -0.3%.
So why would the bond market price a low risk real return asset well above these "expectations"? Does not sound right.

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by Robert T » Mon Dec 21, 2015 2:24 pm

.
Thanks Larry,

Real / Nominal Expected Returns (%)

4.2 / 6.2 = US equity
7.4 / 9.4 = Intl developed equity
9.4 / 11.4 = EM equity

From the above, global equities look okay to me (50:37:13 US:EAFE:EM = 6.1%/8.1% real/nominal return).

According to AQR's capital market assumptions earlier in the year https://www.aqr.com/library/aqr-publica ... et-classes

Real / Nominal Expected Returns (%)

3.8 / 6.0 = US Cap-Wtd
4.8 / 7.0 = US Value
5.7 / 7.9 = US Multi-style

I would just note that the 10 yr forecast inflation rate in the AQR paper = 2.2%

The kicker seems to be more on the bond side.

Real / Nominal Expected Returns (%)

-0.3 / 1.7 = 5 yr
+0.6 / 2.8 = 10 yr (AQR's forecast from the above linked paper. They add a 'roll down' return of 0.6%)

Robert
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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by swl » Mon Dec 21, 2015 2:32 pm

I thought .4 was backwards looking yield and current SEC was negative?
BlueEars wrote:
Geologist wrote:
BlueEars wrote:
The S&P 500 has an expected return a full 4.5 percentage points higher than the five-year Treasury (specifically, the difference between a 4.2% expected return and a -0.3% expected return).
Question for Larry:

Right now the 5 year TIPS are at +0.42%. Why is the expected 5 year Treasury return -0.3% ?
In his first entry in this series (see link), Swedroe has the nominal yield of 5 year Treasuries at 1.7% and the Federal Reserve Bank of Philadelphia's inflation forecast of 2%, therefore he gets a real return to the 5 year Treasury of -0.3%.
So why would the bond market price a low risk real return asset well above these "expectations"? Does not sound right.

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by dc81584 » Mon Dec 21, 2015 2:40 pm

Spot on!

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by quantAndHold » Mon Dec 21, 2015 2:52 pm

EmergDoc wrote:
quantAndHold wrote:
EmergDoc wrote:
Sigh.
I guess my point is that I'm not sure people really believe equity returns will be so low because if they did, their money would flow elsewhere. Perhaps it already is as you've noticed in your area. But the point is that 2% real is a gamechanger. Even increasing it to 3% real is huge, and hopefully you can get that with a small/value/emerging tilt.
Totally agree. Except that I think a lot of money is already trying to chase any alternative that might pay a decent return. Which is why rental property cap rates are at 2%, and there's a whole junk bond fiasco in the making right now.

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by HomerJ » Mon Dec 21, 2015 3:14 pm

EmergDoc wrote:I find your solution to the problem incomplete as I've written here:

http://whitecoatinvestor.com/making-dif ... d-returns/

If you really expect these terribly low returns, that completely changes the game.
Exactly.

(1) Why do people expect these terribly low returns? CAPE 10 is not very predictive even in the best of times, and it's been quite terrible over the past few decades. CAPE 10 has been above 20 for the past 23 years, and yet we have still gotten decent returns. Far better than the OP is predicting now. In fact, investing at CAPE 10 of 45 in 2000 has returned more over the past 15 years than the OP is "expecting" at CAPE 10 of 25 today. So what other variables is he considering?

(2) For how long are we expecting these terribly low returns? The stock market doesn't return a reliable 10% nominal every year. It quite often does give out low return decades followed by high return decades that average out to 10%.. Why are we trying to predicting the low return decades, when just buying and holding through both types of markets ends up giving one a very good return (so far). Are we "expecting" 4.3% forever? For the next 5 years? For the next 10 years? For the next 30 years?
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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by larryswedroe » Mon Dec 21, 2015 3:19 pm

EmergencyDoc
You seem to be forgetting a few important issues with individual properties, like all the headaches and time involved in being a manager of the property and dealing with tenants and repairs, etc. At very least a cost should be imposed for those issues. And of course the inability to broadly diversify the risks, which means you are taking uncompensated risk. IMO unless that's your business you shouldn't be in it.
Just my opinion.
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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by randomguy » Mon Dec 21, 2015 3:23 pm

EmergDoc wrote:I find your solution to the problem incomplete as I've written here:

http://whitecoatinvestor.com/making-dif ... d-returns/

If you really expect these terribly low returns, that completely changes the game. All kinds of other things to do with your money- like buying investing properties now look more attractive. I was also surprised to see you didn't mention taking more small and value risk in addition to more equity risk.

But 2% real means your money only doubles once in 3-4 decades. If I really believed that, I'd be walking around my neighborhood buying every property that came up for sale, paying cash for it, and enjoying my 4-6% real returns on completely paid for houses. It's not hard at all to find houses with cap rates of 4-6%. Real estate investors don't even look at those.
The problem is that you need to make that choice now, not when it is apparent that real returns are going to be 2%. For example, what is a likely case for a 2% decade? Something like losing 30-40% over 2-3 years and then having ~9-10% returns for the rest of the decade. The people that went to real estate in year 0, make money over stocks. The ones that go to real estate in year 3 (when stocks are down 40%), lose money compared to staying the course. Obviously there are other cases (stocks double and then drop 40% puts you in about the same spot), maybe we have some japanese type case (drop of say 40% over 5 years, and then make 5%/yr for 25 years), and so on.

The obvious answer is diversification. You do run into the issues that private real estate or equity isn't as remotely as easy as writing a check to vanguard.

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by White Coat Investor » Mon Dec 21, 2015 3:41 pm

larryswedroe wrote:EmergencyDoc
You seem to be forgetting a few important issues with individual properties, like all the headaches and time involved in being a manager of the property and dealing with tenants and repairs, etc. At very least a cost should be imposed for those issues. And of course the inability to broadly diversify the risks, which means you are taking uncompensated risk. IMO unless that's your business you shouldn't be in it.
Just my opinion.
Larry
Absolutely there is additional risk. And of course a cost of managing (although I think you can get that within the 45% of rent I was allocating to non-mortgage expenses.) But I'm talking about a property that isn't a deal and that isn't leveraged at all. It doesn't take much looking to purchase a cap rate 6 property and you can get that return up to 9-12% pretty easily with leverage.

My point is if it's going to take me 4 decades to double my money in stocks and bonds, I'm going to ditch stocks and bonds and do something else. And you should be doing the same for your clients!

I can get a guaranteed 0% real return and a projected 2-3% real return out of whole life insurance held for a lifetime. Why buy stocks if they're not going to do any better than that?
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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by Rodc » Mon Dec 21, 2015 4:02 pm

My point is if it's going to take me 4 decades to double my money in stocks and bonds, I'm going to ditch stocks and bonds and do something else. And you should be doing the same for your clients!
I suspect that for someone in accumulation with 20 or more years to go this will not be the case even if from here this is true, because markets go up and down and as soon as the market drops it is likely stocks will be be a better buy. If one puts significant money into play in the future those returns will average with the returns on current money. Simply put, the markets will no stay as they are for 40 years.

If one is finished with investing and what they have today is all they will ever have (plus returns of course) this is a possible issue.

If one is moderately close to retiring, and thus new money is only modest the situation is in the middle.
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.

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by Day9 » Mon Dec 21, 2015 4:17 pm

It seems like the pattern of this article series is to analyze ways to increase expected return of your portfolio other than increasing your stock allocation. I doubt that Larry will discuss using leverage but I wish he would.

In one of his Only Guide... books (all of which I highly recommend) Larry pointed out the fees associated with leverage mean you aren't appropriately compensated for the added risk. But the fees and implied financing costs of treasury and index equity futures contracts is very low although rolling contracts has tax implications. If your need, desire, and willingness to take risk lead you to a 100% stock allocation where you do not benefit from diversifying to bonds then it is possible that the diversification benefits in a modestly leveraged, diversified portfolio could outweigh the added risks and costs of leverage.

I think this would be an appropriate article series to touch on the subject because it seems to be about alternatives to raising your stock allocation.
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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by larryswedroe » Mon Dec 21, 2015 5:08 pm

Day9
I would never recommend leverage use by individuals to buy equity risks, or debt risks. You cite the basic reasons. And I would add many people already levered by their mortgage
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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by randomguy » Mon Dec 21, 2015 6:15 pm

EmergDoc wrote:
larryswedroe wrote:EmergencyDoc
You seem to be forgetting a few important issues with individual properties, like all the headaches and time involved in being a manager of the property and dealing with tenants and repairs, etc. At very least a cost should be imposed for those issues. And of course the inability to broadly diversify the risks, which means you are taking uncompensated risk. IMO unless that's your business you shouldn't be in it.
Just my opinion.
Larry
Absolutely there is additional risk. And of course a cost of managing (although I think you can get that within the 45% of rent I was allocating to non-mortgage expenses.) But I'm talking about a property that isn't a deal and that isn't leveraged at all. It doesn't take much looking to purchase a cap rate 6 property and you can get that return up to 9-12% pretty easily with leverage.

My point is if it's going to take me 4 decades to double my money in stocks and bonds, I'm going to ditch stocks and bonds and do something else. And you should be doing the same for your clients!

I can get a guaranteed 0% real return and a projected 2-3% real return out of whole life insurance held for a lifetime. Why buy stocks if they're not going to do any better than that?
Given that you can get 9-12% why wouldn't you be loading up on properties? In the best of times stocks returning 9-12% is about as good as it gets over 20+ year periods. Personally I am not because I don't have the time to run a second business and I am not convinced that being dumb money (i.e. depending on the real estate agent and the property management company to tell me if the deal is good) is going to give me decent returns. Of course I am also expecting a few more percentages of return especially as we extend the term from 10 years to 20+

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by Rx 4 investing » Mon Dec 21, 2015 6:45 pm

Homer J asked: "For how long are we expecting these terribly low returns? The stock market doesn't return a reliable 10% nominal every year. It quite often does give out low return decades followed by high return decades that average out to 10%.. Why are we trying to predicting the low return decades, when just buying and holding through both types of markets ends up giving one a very good return (so far). Are we "expecting" 4.3% forever? For the next 5 years? For the next 10 years? For the next 30 years? "
From Lance Roberts "5 Investing Myths That Will Hurt You": http://realinvestmentadvice.com/5-inves ... -hurt-you/

"The chart below compares Shiller’s 10-year CAPE to 20-year actual forward returns from the S&P 500 levels; history suggests returns to investors over the next 20-years will likely be lower than higher. We can also prove this mathematically as well as shown..."

Image
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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by Twins Fan » Mon Dec 21, 2015 8:30 pm

Speaking of mortgages...

Would the lower expected returns going forward make a better case for paying off or down a 3% or 4% mortgage and getting a guaranteed return?

I know tax deductions and liquidity and all the other stuff that comes up that way.... But, maybe going forward paying down or off debt isn't to be looked down on like it often is. Or, maybe it should be looked at more to pay down or off debt on the fixed income side of things.

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by larryswedroe » Mon Dec 21, 2015 8:38 pm

twinsfan
I almost always recommend paying down debt, as long as debt cost is current rate or higher. Reason simple, it's the highest riskless return you can generally get. Now if very young and high marginal utility of wealth and there's a large ERP you might consider keeping debt. But there are many advantages, including psychological benefits, for paying down debt. I was Vice Chairman of the largest private mortgage company in country and I didn't have a mortgage.
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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by Grt2bOutdoors » Mon Dec 21, 2015 9:12 pm

EmergDoc wrote:
larryswedroe wrote:EmergencyDoc
You seem to be forgetting a few important issues with individual properties, like all the headaches and time involved in being a manager of the property and dealing with tenants and repairs, etc. At very least a cost should be imposed for those issues. And of course the inability to broadly diversify the risks, which means you are taking uncompensated risk. IMO unless that's your business you shouldn't be in it.
Just my opinion.
Larry
Absolutely there is additional risk. And of course a cost of managing (although I think you can get that within the 45% of rent I was allocating to non-mortgage expenses.) But I'm talking about a property that isn't a deal and that isn't leveraged at all. It doesn't take much looking to purchase a cap rate 6 property and you can get that return up to 9-12% pretty easily with leverage.

My point is if it's going to take me 4 decades to double my money in stocks and bonds, I'm going to ditch stocks and bonds and do something else. And you should be doing the same for your clients!

I can get a guaranteed 0% real return and a projected 2-3% real return out of whole life insurance held for a lifetime. Why buy stocks if they're not going to do any better than that?
You buy because future expectations are low, no different than value investing. A few good unexpected surprises and the money will come rushing back in, bidding up those formerly cheap assets. Do you really believe whole life is going to beat out a diversified portfolio of low cost funds, after all those articles you wrote on whole life? What do you think life insurance companies invest their money in? It's not different this time.
"One should invest based on their need, ability and willingness to take risk - Larry Swedroe" Asking Portfolio Questions

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by randomguy » Mon Dec 21, 2015 9:37 pm

Rx 4 investing wrote:
Homer J asked: "For how long are we expecting these terribly low returns? The stock market doesn't return a reliable 10% nominal every year. It quite often does give out low return decades followed by high return decades that average out to 10%.. Why are we trying to predicting the low return decades, when just buying and holding through both types of markets ends up giving one a very good return (so far). Are we "expecting" 4.3% forever? For the next 5 years? For the next 10 years? For the next 30 years? "
From Lance Roberts "5 Investing Myths That Will Hurt You": http://realinvestmentadvice.com/5-inves ... -hurt-you/

"The chart below compares Shiller’s 10-year CAPE to 20-year actual forward returns from the S&P 500 levels; history suggests returns to investors over the next 20-years will likely be lower than higher. We can also prove this mathematically as well as shown..."

Image
When you look at that chart, you have to realize that pretty much all of the of the 25+ PE10s are from 1 period of time in US history (i.e. 1929, maybe a brief period in 1966. I don't have monthly quarterly handy). I am guessing he is plotting something like quarterly or monthly to add in more dots.

For example imagine we add in using current returns
1996 (24.7) - 8.6 CAGR
1997 (28.3 ) - 8.0
1998 (32.8)- 6.8
1999 (40)- 5.8%
That chart would look a lot different with a big cluster well above the box. We we get those added years or will a correction reduce them before we hit the 20 year mark? Who knows.

The 3% of 1929-1948 was bad. You want to guess how much was a result of the PE10, the great depression (we can debate how related they were), and WWII?

And of course we can have the debate that where we are now should be centered on 20 not 25. Notice there that cluster of dots around 7-8%. I am guessing those are the early 90s:)

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by Joe Jones » Mon Dec 21, 2015 10:49 pm

Mr. Swedroe,

Thank you for sharing your articles! They seem like reasonable advice under any market conditions.

I'm a lay-person, just enjoying learning about investing, so please don't take this as a challenge.

I’ve been reading A Random Walk Down Wall Street by Burton G. Malkiel. At the end of the section titled Bubbles and Economic Activity, on page 105, Malkiel writes:
Stock valuations depend upon estimations of the earning power of companies many years into the future. Such forecasts are invariably incorrect. Moreover, investment risk is never clearly perceived, so the appropriate rate at which the future should be discounted is never certain. Thus, market prices must always be wrong to some extent. But at any particular time, it is not obvious to anyone whether they are too high or too low. The evidence I will present next shows that professional investors are not able to adjust their portfolios so that they hold only “undervalued” stocks and avoid “overvalued” ones. The fact that the best and the brightest on Wall Street cannot consistently distinguish correct valuations from incorrect ones shows how hard it is to beat the market. There is no evidence that anyone can generate excess returns by making consistently correct bets against the collective wisdom of the market. Markets are not always or even usually correct. But NO ONE PERSON OR INSTITUTION CONSISTENTLY KNOWS MORE THAN THE MARKET.
(I'm not screaming in CAPS, they’re in the book;)

The conversation regarding forecasts and valuations raises questions for me. I’m looking forward to reading more here and putting it together with books offline. What an education! I appreciate it.

Happy Holidays,
Joe
0+2=1

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by packer16 » Mon Dec 21, 2015 11:46 pm

One aspect of REITs that is not discussed much is expense ratios. If you can buy an low expense ratio REIT you can save up to 5% on fees and that additional return goes to your bottom line. For example, in healthcare you can buy MPW with and expense ratio of 2% and a dividend yield of 8% versus HR with a expense ratio of 5.5% and a yield of 4.8%. Both have the same expected return but you keep more with MPW versus HR. As you would expect MPW has growing FFO/share while HCN has a declining one in part due to expenses.

If you believe the RE market is becoming more efficient & I do, then as with the stock market, low costs/fees will win in RE much the same as in the stock market, call it the Boglehead approach to RE investment.

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by Maynard F. Speer » Tue Dec 22, 2015 12:31 am

Joe Jones wrote:Mr. Swedroe,

Thank you for sharing your articles! They seem like reasonable advice under any market conditions.

I'm a lay-person, just enjoying learning about investing, so please don't take this as a challenge.

I’ve been reading A Random Walk Down Wall Street by Burton G. Malkiel. At the end of the section titled Bubbles and Economic Activity, on page 105, Malkiel writes:
Stock valuations depend upon estimations of the earning power of companies many years into the future. Such forecasts are invariably incorrect. Moreover, investment risk is never clearly perceived, so the appropriate rate at which the future should be discounted is never certain. Thus, market prices must always be wrong to some extent. But at any particular time, it is not obvious to anyone whether they are too high or too low. The evidence I will present next shows that professional investors are not able to adjust their portfolios so that they hold only “undervalued” stocks and avoid “overvalued” ones. The fact that the best and the brightest on Wall Street cannot consistently distinguish correct valuations from incorrect ones shows how hard it is to beat the market. There is no evidence that anyone can generate excess returns by making consistently correct bets against the collective wisdom of the market. Markets are not always or even usually correct. But NO ONE PERSON OR INSTITUTION CONSISTENTLY KNOWS MORE THAN THE MARKET.
(I'm not screaming in CAPS, they’re in the book;)

The conversation regarding forecasts and valuations raises questions for me. I’m looking forward to reading more here and putting it together with books offline. What an education! I appreciate it.

Happy Holidays,
Joe
Just my 2c ..

- In the early 80s, Warren Buffett disputed Malkiel's claim - that no one 'can generate excess returns by making consistently correct bets against the collective wisdom of the market' - in his article The Superinvestors of Graham and Doddsville ... He took Malkiel's data on the performance of active fund managers, and split it up - identifying a specific breed of 'value' investor who did seem to consistently outperform;

- In the early 90s - and with information and data much more freely available and scrutinisable - Eugene Fama and Kenneth French noted that two classes of stocks (smaller companies and companies with low price/book ratios) did seem to outperform the market as a whole, and sought to explain this in terms of the investor taking on more risk and being compensated for that risk .. The Fama-French Three-Factor Model;

- In the early 00s, Robert Shiller got us thinking about 'behavioural finance', in Irrational Exuberance .. This popularised the CAPE ratio (that we all know today) and showed that, at extremes, it was a pretty good gauge of market sentiment - between greed and fear - and that market participants collectively tend to overreact to both

Today, I think it's fair to say all of these perspectives - from markets behaving efficiently, to being compensated for taking on risk, to investor psychology displaying certain predictable patterns - come together to form a more complete view of the emergent intelligence of markets
"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

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by White Coat Investor » Tue Dec 22, 2015 1:06 am

Grt2bOutdoors wrote:
EmergDoc wrote:
larryswedroe wrote:EmergencyDoc
You seem to be forgetting a few important issues with individual properties, like all the headaches and time involved in being a manager of the property and dealing with tenants and repairs, etc. At very least a cost should be imposed for those issues. And of course the inability to broadly diversify the risks, which means you are taking uncompensated risk. IMO unless that's your business you shouldn't be in it.
Just my opinion.
Larry
Absolutely there is additional risk. And of course a cost of managing (although I think you can get that within the 45% of rent I was allocating to non-mortgage expenses.) But I'm talking about a property that isn't a deal and that isn't leveraged at all. It doesn't take much looking to purchase a cap rate 6 property and you can get that return up to 9-12% pretty easily with leverage.

My point is if it's going to take me 4 decades to double my money in stocks and bonds, I'm going to ditch stocks and bonds and do something else. And you should be doing the same for your clients!

I can get a guaranteed 0% real return and a projected 2-3% real return out of whole life insurance held for a lifetime. Why buy stocks if they're not going to do any better than that?
You buy because future expectations are low, no different than value investing. A few good unexpected surprises and the money will come rushing back in, bidding up those formerly cheap assets. Do you really believe whole life is going to beat out a diversified portfolio of low cost funds, after all those articles you wrote on whole life? What do you think life insurance companies invest their money in? It's not different this time.
Of course I don't. That's why I'm still holding a stock/bond portfolio. What I'm saying is that if you believe your portfolio is only going to get 0-2% real, you might want to consider it. You can get 2-2.5% nominal guaranteed from the insurance company, and 4-6% nominal projected on current dividend scales if you hold for a very long time.

People have been predicting these low returns for several years now. They called the 2000s the lost decade. Yet since I started investing in 2004 I have about a 6% real return on my tilted 75/25 portfolio. Well, if that's the lost decade, I think I can reach my goals with a few more of them.

I agree with those who say that perhaps returns will be low for the next 10 years, but the next ten years is awfully hard to predict from here, and if the next 10 years have low returns the 10 after that are likely not to. And that scenario would work out pretty awesomely for me as a mid-career accumulator.
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

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by White Coat Investor » Tue Dec 22, 2015 1:08 am

larryswedroe wrote:twinsfan
I almost always recommend paying down debt, as long as debt cost is current rate or higher. Reason simple, it's the highest riskless return you can generally get. Now if very young and high marginal utility of wealth and there's a large ERP you might consider keeping debt. But there are many advantages, including psychological benefits, for paying down debt. I was Vice Chairman of the largest private mortgage company in country and I didn't have a mortgage.
Larry
Interesting. I've never heard you talk about that before.
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

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by galeno » Tue Dec 22, 2015 1:10 am

According to Larry's numbers our portfolio has a nominal expected CAGR = 5.5%. Inflation = 2.0%. I'll add GSD = 10%. TER = 0.40%. AWR = 3.0%. Term = 37 years.

Plugging these numbers into FireCalc our port has a success rate = 85%.
AA = 40/55/5. Expected CAGR = 3.8%. GSD (5y) = 6.2%. USD inflation (10 y) = 1.8%. AWR = 4.0%. TER = 0.4%. Port Yield = 2.13%. Term = 34 yr. FI Duration = 6.2 yr. Portfolio survival probability = 95%.

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by james22 » Tue Dec 22, 2015 6:22 am

larryswedroe wrote:Increase Your Equity Allocation
I'll Increase My Cash Allocation and wait for lower equity valuations/higher expected returns.
This whole episode is likely to end so badly that future children will learn about it in school and shake their heads in wonder at the rank stupidity of it all... Hussman

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by larryswedroe » Tue Dec 22, 2015 8:14 am

Joe
Malkiel is referring to people's OPINIONS about where the market is going. A good example would be Jeremy Grantham of GMO who for years used the CAPE 10 to state the market was overvalued, and was forecasting a RTM of valuations and thus a big bad bear market. Those who use the CAPE 10 in way I did are saying the market's price is the best estimate of the RIGHT price and thus assume no change in valuations. It's the high valuations we have today in US that thus are forecasting low future returns, not me. I'm just taking the market's price as the forecast, just as you would take the current yield on a 10 year bond to be the forecast of the return on a 10 year bond you bought today.
I hope that is helpful
Larry

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by Johno » Tue Dec 22, 2015 8:22 am

EmergDoc wrote:
quantAndHold wrote:
EmergDoc wrote: But 2% real means your money only doubles once in 3-4 decades. If I really believed that, I'd be walking around my neighborhood buying every property that came up for sale, paying cash for it, and enjoying my 4-6% real returns on completely paid for houses. It's not hard at all to find houses with cap rates of 4-6%. Real estate investors don't even look at those.
That would be great, if the cap rates on everything in my local area weren't also at about 1-2%. In a lot of big cities there are a couple of well funded companies sweeping in and paying all cash for every house that would make a decent rental.

Sigh.
I guess my point is that I'm not sure people really believe equity returns will be so low because if they did, their money would flow elsewhere. Perhaps it already is as you've noticed in your area. But the point is that 2% real is a gamechanger. Even increasing it to 3% real is huge, and hopefully you can get that with a small/value/emerging tilt.
My perspective is more similar to quantAndHold's. It's difficult to find properties that yield 4% in my area, those would be ones with special issues/problems even for a rental property. And the kind of properties I want, similar to existing best performers more like 2% without getting a below market deal. RE success is arguably about making special risks work and getting below market deals. Also people are bidding up hot properties hoping for more of the same appreciation they've experienced not just yield, and in direct RE trends c,an be stronger and longer lived than in financial assets so that hope isn't necessarily unreasonable. But for purposes of calculating expected return I assume real return=yield, appreciation at inflation (knowing of course it doesn't even have to be that high).

So I see RE as diversifying but not really getting away from the problem of (IMO) ~3-4% real expected return in (globally diversified) stocks pre tax, and I calc my whole portfolio's after tax (only small % tax deferred) real expected return around 1.5% including a notional liability for unrealized capital gains tax, or 2.2% assuming all the gains will be swept away by basis step up, reality in between but probably closer to the latter.

IOW 'I'd just do X completely differently if I though E[r] was 2%' depends on the person. I see that as the fair expectation, maybe on the conservative side, but anyway I see no way to fundamentally sidestep it. I think your point is still interesting though in that it's clear many retail buy and hold investors believe in higher expected returns than that, and some others, plus institutions as a rule believe they can 'expect' to get higher than market returns. How would the market change if they all saw markets as I do? I don't know.

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by galeno » Tue Dec 22, 2015 8:39 am

Total World Stock Market = 52% USA + 40% Developed non-USA + 8% Emerging Markets. Expected REAL CAGRs for: TWSM = 5.5%. For TBM = 0.3%. CASH = -2.0%.

Buy and hold TWSM vs TSM should deliver TWICE as much return.

This thread is the main reason I disagree with John Bogle's 100% nativist tilt of 100% USA equities. Forecasts are not perfect. But they are better than guesses and feelings.

I like Kirk. I bet on Spock.
AA = 40/55/5. Expected CAGR = 3.8%. GSD (5y) = 6.2%. USD inflation (10 y) = 1.8%. AWR = 4.0%. TER = 0.4%. Port Yield = 2.13%. Term = 34 yr. FI Duration = 6.2 yr. Portfolio survival probability = 95%.

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by afan » Tue Dec 22, 2015 10:05 am

duplicate post
Last edited by afan on Tue Dec 22, 2015 10:08 am, edited 1 time in total.
We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either | --Swedroe | We assume that markets are efficient, that prices are right | --Fama

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by afan » Tue Dec 22, 2015 10:05 am

If the market is efficient, if prices are right, then one increases expected return by increasing risk. That is, by increasing allocation to risky assets.

Investors care about risk and risk adjusted return. This discussion does not address whether valuations help predict risk adjusted returns. If one thought one could predict risk adjusted returns using valuations then one would do well to adjust asset allocation based on these predictions. But if one cannot predict changes in expected risk adjusted return, then these changes in expected return should not lead to changes in asset allocation.

One should always seek to maximize risk adjusted return, and use asset allocation to put expected risk in a target range. Asset allocation should change when either risk tolerance changes or expected risk changes. If there is no basis for changing forecast risk, and so far no one on this thread has discussed such a basis, then there is no basis for changing asset allocation.

I am puzzled by the statements that one can get some definite level of return on real estate investing. This seems to imply known price behavior of the real estate. One can make a forecast, a guess, about future price behavior of real estate, but no one should consider any such forecast as anything approaching a reliable return.

There are enough studies of CAPE 10 performance in predicting long term stock behavior to have an idea of the error bars around the prediction. They are substantial, with the valuation indicator explaining a statistically significant but small fraction of the variation in stock prices. I have not seen any work on the performance of various adjustments to CAPE 10. It seems intuitively appealing that current accounting rules give a better picture of corporate earnings than they would have in the past. Whether that means the effective PE should be adjusted and by how much are empirical questions that should have empirical answers. Does anyone know of studies of this?

Similarly, changes in regulation now render illegal, and therefore less common, some practices that may have occurred frequently in the past. I agree this should reduce risk and might justify a higher price for a given level of reported earnings. But does this adjustment actually improve price forecasting over the unadjusted CAPE 10? Anyone know of data on that?

For these and other components of price prediction, it would be really nice to see a summary of performance of simple long term average, prediction using unadjusted CAPE 10, prediction using adjusted CAPE 10 and prediction using any of these metrics along with current state of inflation, interest rates, and what ever else one might want to use.

There is a serious risk of data mining in looking at retrospective information, but at least one could draw error bars around the predictions and ask whether they are narrow enough to pay them heed.

My risk tolerance has not changed, I still believe markets are efficient, so I see no reason to change my asset allocation.

As Larry said in part 1, earn more, spend less. Always good advice.
We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either | --Swedroe | We assume that markets are efficient, that prices are right | --Fama

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by Artsdoctor » Tue Dec 22, 2015 10:17 am

I don't think there's any surprise here. Thank you, Larry, for the pointers. Calling for a 2% real return has been something most reasonable people, much smarter than me, having been predicting for the past two years.

No one can predict the future, and if real returns are greater than that, terrific. But if you're making your investment decisions--and life decisions--thinking that you're going to make a 5% real return over the next decade, you will have at least been warned by nearly everyone around you that you may well come up short (except pension funds, of course).

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by Maynard F. Speer » Tue Dec 22, 2015 10:41 am

afan wrote:There are enough studies of CAPE 10 performance in predicting long term stock behavior to have an idea of the error bars around the prediction. They are substantial, with the valuation indicator explaining a statistically significant but small fraction of the variation in stock prices. I have not seen any work on the performance of various adjustments to CAPE 10. It seems intuitively appealing that current accounting rules give a better picture of corporate earnings than they would have in the past. Whether that means the effective PE should be adjusted and by how much are empirical questions that should have empirical answers. Does anyone know of studies of this?
I posted this in the first thread .. Sometimes when you see it plotted like this, you get an idea of just how closely returns have followed valuations

Image

The Philosophical Economics blog attempted to improve CAPE, but I think came to the conclusion it probably works best as it is ... The other thing to realise is CAPE paints a generally more optimistic picture than most other valuation metrics

Being a valuations type (and typically a pessimist), I can say one of the best hopes for US stocks is that the high sector weightings in tech and healthcare in the index today *could* explain a sizeable proportion of current valuations .. The metrics we use are quite crude and old-fashioned, and in sectors like healthcare and tech, there can be considerable value hidden in things like intellectual property
"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

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by ZenInvestor » Tue Dec 22, 2015 11:22 am

I think you are missing a big piece of the personal finance picture in this. My strategy for the past 3 years has been to reduce risk through the elimination of debt and increase my exposure to equities. Take for example:

Example Mortgage 4.5% - 25% tax savings = 3.37% nominal return - 2% inflation = 1.37% real return
Example Student Loan 8% - 2% inflation = 6% real return

I think people who are maybe 60/40 should consider paying off their mortgage and all other debt and moving to like a 90/10. The blended return would be MUCH better. Example

60/40: (4.2% Equity Return * 60) + (-0.3 bond return * 40) = 2.4% return

90/10/pay off mortgage: (4.2% Equity Return * 60) + (-0.3 bond return * 10) + (3.37% mortgage return * 30) = 3.4% return

Both would have comparable risk, but clearly paying off the mortgage should be considered as a potential lever

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by ND Fan 1 » Tue Dec 22, 2015 11:40 am

larryswedroe wrote:http://www.etf.com/sections/index-inves ... nopaging=1

Offering several options investors should CONSIDER

Hope you find it helpful
Larry

Question on he Emerging Market tilt. You state EM is about 25% of the international market, so should you multiply your International Equity position by 25% to get a EM tilt? What if your core fund is the VG total International that already includes EM? Could you just hold the Total International? I would like to keep my international allocation as simple as possible. Example

Proposed Asset Allocation
Overall 85/15 Stock/Bond Split
US equity- 65 % of total equity
Total Stock Index- 70% of US equity (39% of portfolio total)
Small Cap Value- 15% of US equity (8% portfolio total)
REIT- 15% of US equity (8% portfolio total)

International 35% of equity (30% portfolio total)
Total International Index- 75% of international equity (23% portfolio total)
EM- 25% of international equity (7% of portfolio total)

15%- TSP G Fund

Would this portfolio be in line with what you are recommending in your article?

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by galeno » Tue Dec 22, 2015 11:41 am

Exactly. The forecasts are not perfect. But they are accurate enough. Far more accurate vs feelings and hunches. With Larry's forecasts our portfolio can handle an initial 3% AWR and sustain it for 37 years with an 80% probability of success.

<I posted this in the first thread .. Sometimes when you see it plotted like this, you get an idea of just how closely returns have followed valuations>
AA = 40/55/5. Expected CAGR = 3.8%. GSD (5y) = 6.2%. USD inflation (10 y) = 1.8%. AWR = 4.0%. TER = 0.4%. Port Yield = 2.13%. Term = 34 yr. FI Duration = 6.2 yr. Portfolio survival probability = 95%.

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by larryswedroe » Tue Dec 22, 2015 11:51 am

ND
The most efficient way to hold any asset is in a total market fund. So that would include Vanguard Total International. That eliminates your need to rebalance with your own assets. And it also eliminates the need for funds to sell and buy securities if countries migrate between developed and EM.
Only reason to own them separately is if you want to tilt more than market.
So let's say EM is 25% of international, non-US, or 12.5% of total market roughly. And you want 20% EM. So you own the total international getting you to 12.5% and then add 8% EM.
Now I'm assuming Vanguard fund holds about that weight of 25%. You should check
Larry

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Re: Part 2 of the perfect storm post, how to increase EXPECTED returns

Post by magneto » Tue Dec 22, 2015 11:58 am

"That said, it must be noted that international stocks have lower valuations for a reason. They are perceived to be riskier. In other words, the higher expected returns are not a free lunch."

The PEG (PE/Growth) ratio whether PE1 or PE10 will be very much determined by the variability from country to country of Earnings Growth, back calculated to own domestic currency (e.g. US$). We need to get a handle on country growth rates. The following highlights the historical disparities between countries and the ensuing difficulties :-

http://www.researchaffiliates.com/Asset ... ities.aspx

As mentioned by a previous poster Rental Real Estate is an attractive option (allowance being made for the hassle factor, say -1.5%?). Would suggest however the aim of 'A Well Balanced Portfolio' should ideally to be to include all four of the main income producing assets. Even with exposure to RRE we are still stuck with the problem of how to apportion our stock holdings. :!:
'There is a tide in the affairs of men ...', Brutus (Market Timer)

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