philosophicaleconomics predicts 4% real equity returns

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marcopolo
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Re: philosophicaleconomics predicts 4% real equity returns

Post by marcopolo » Fri Feb 16, 2018 11:40 pm

JBTX wrote:
Fri Feb 16, 2018 6:12 pm
willthrill81 wrote:
Fri Feb 16, 2018 6:02 pm
JBTX wrote:
Fri Feb 16, 2018 6:01 pm
willthrill81 wrote:
Fri Feb 16, 2018 4:42 pm
JBTX wrote:
Fri Feb 16, 2018 4:34 pm


Of course earnings will likely grow, but do you expect earnings to grow faster than overall gdp growth?
Maybe, but I don't know. My crystal ball is pretty cloudy. :confused
As to 5% real I hope your right but wouldn’t bet on it. I’m using 3% real.

5% real equities or on entire portfolio?
Equities, including international and EM.

No betting is necessary. If I get 3% real, it may just mean that I retire at 52 instead of 50.
Including international i could see 5% as more plausible although it still seems a bit high. I agree it is mostly an academic exercise. Most people adapt as needed. I likely won’t retire until around 59, but it depends on what I’m doing and how I’m liking it. I tend to shoot for a 3% SWR and 3% real for entire portfolio.
Interesting discussion.

After all of that, it appears the two of you are essentially using the same assumptions!

Will's 5% real for planning is for equities only, and includes international and EM.
JBTX is planning for 3% real for the entire portfolio, which if we assume he/she has a good portion of the portfolio in bonds (at around 1% real?) probably requires something close to 5% from the equity side (including INTL/EM).
Once in a while you get shown the light, in the strangest of places if you look at it right.

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siamond
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Re: philosophicaleconomics predicts 4% real equity returns

Post by siamond » Fri Feb 16, 2018 11:42 pm

willthrill81 wrote:
Fri Feb 16, 2018 11:11 am
However, I'm not sure that I buy the real return argument, even though CAPE has had stronger correlations with real returns than nominal. I'm not aware of anyone who has identified how CAPE should have anything to do with inflation, and a real return is merely a nominal one less inflation. There is no logical reason why CAPE should be a better predictor of nominal returns and inflation than just nominal returns. Consequently, I currently chalk this one up to coincidence.
Er, I'm afraid you got this backwards. CAPE has nothing to do with inflation (because the inflation factor in the denominator and the numerator cancel each other), therefore there is no logical reason why 1/CAPE should be a better predictor of nominal returns than of real returns, given the extremely random nature of (past) inflation.

Looking at correlation alone misses a large part of the picture, as correlation doesn't care about amplitude nor average values, it only measures directionality.

From an empirical standpoint, when you look at the track record (yeah, I ran all this math in depth, among numerous other people), it is plainly obvious as the average of 1/CAPE (for a given starting year) is indeed very close to the average realized real returns over a decade or more (following this starting year), for the known history. Sure, with a LOT of dispersion around the actuals, which makes it an extremely blunt tool, but still 1/CAPE is a real quantity, no question about it.

There is also a more mathematical explanation of why 1/CAPE makes sense as an expected (real) returns model, but this will be for another post...

JBTX
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Re: philosophicaleconomics predicts 4% real equity returns

Post by JBTX » Sat Feb 17, 2018 1:44 am

marcopolo wrote:
Fri Feb 16, 2018 11:40 pm
JBTX wrote:
Fri Feb 16, 2018 6:12 pm
willthrill81 wrote:
Fri Feb 16, 2018 6:02 pm
JBTX wrote:
Fri Feb 16, 2018 6:01 pm
willthrill81 wrote:
Fri Feb 16, 2018 4:42 pm


Maybe, but I don't know. My crystal ball is pretty cloudy. :confused
As to 5% real I hope your right but wouldn’t bet on it. I’m using 3% real.

5% real equities or on entire portfolio?
Equities, including international and EM.

No betting is necessary. If I get 3% real, it may just mean that I retire at 52 instead of 50.
Including international i could see 5% as more plausible although it still seems a bit high. I agree it is mostly an academic exercise. Most people adapt as needed. I likely won’t retire until around 59, but it depends on what I’m doing and how I’m liking it. I tend to shoot for a 3% SWR and 3% real for entire portfolio.
Interesting discussion.

After all of that, it appears the two of you are essentially using the same assumptions!

Will's 5% real for planning is for equities only, and includes international and EM.
JBTX is planning for 3% real for the entire portfolio, which if we assume he/she has a good portion of the portfolio in bonds (at around 1% real?) probably requires something close to 5% from the equity side (including INTL/EM).
Yes that thought actually occurred to me. It forces the uncomfortable conclusion that 3% real for a 60/40’portfolio may be too high. Perhaps 2% real, but that just seems so low and almost on the verge of pointless from an investing perspective. Maybe 2.5%. I’m going to have to ponder this. Maybe a case of the numbers being what they are and I just don’t want to accept the answer.

WanderingDoc
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Re: philosophicaleconomics predicts 4% real equity returns

Post by WanderingDoc » Sat Feb 17, 2018 2:15 am

JBTX wrote:
Sat Feb 17, 2018 1:44 am
marcopolo wrote:
Fri Feb 16, 2018 11:40 pm
JBTX wrote:
Fri Feb 16, 2018 6:12 pm
willthrill81 wrote:
Fri Feb 16, 2018 6:02 pm
JBTX wrote:
Fri Feb 16, 2018 6:01 pm


As to 5% real I hope your right but wouldn’t bet on it. I’m using 3% real.

5% real equities or on entire portfolio?
Equities, including international and EM.

No betting is necessary. If I get 3% real, it may just mean that I retire at 52 instead of 50.
Including international i could see 5% as more plausible although it still seems a bit high. I agree it is mostly an academic exercise. Most people adapt as needed. I likely won’t retire until around 59, but it depends on what I’m doing and how I’m liking it. I tend to shoot for a 3% SWR and 3% real for entire portfolio.
Interesting discussion.

After all of that, it appears the two of you are essentially using the same assumptions!

Will's 5% real for planning is for equities only, and includes international and EM.
JBTX is planning for 3% real for the entire portfolio, which if we assume he/she has a good portion of the portfolio in bonds (at around 1% real?) probably requires something close to 5% from the equity side (including INTL/EM).
Yes that thought actually occurred to me. It forces the uncomfortable conclusion that 3% real for a 60/40’portfolio may be too high. Perhaps 2% real, but that just seems so low and almost on the verge of pointless from an investing perspective. Maybe 2.5%. I’m going to have to ponder this. Maybe a case of the numbers being what they are and I just don’t want to accept the answer.
Thats why I'm going to put 10-20% of investible assets each year into paper. I know that my real estate investments will outperform equities all day every day even on its worst year, but I am stubborn and I'd rather convince myself with data by investing for 10-15 years, and proving to myself what I already know that mutual funds will be a bad investment over the next 10-15 years. In the recent past they were an okay investment, but I think they will be 'bad' going forward (relative to real estate).
Don't wait to buy real estate. Buy real estate, and wait. | Rent where you live, buy where others pay your mortgage for you.

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in_reality
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Re: philosophicaleconomics predicts 4% real equity returns

Post by in_reality » Sat Feb 17, 2018 2:35 am

Wow!

The most interesting thing about this article is the difference between a company paying dividends or using the money for reinvestment in the company.

It is commonly asserted here that there is no difference between paying out a dividend and retaining the earnings (to grow the company). For example:
investors should be indifferent to $1 in the form of a dividend (causing the stock price to drop by $1) and $1 received by selling shares. This must be true, unless you believe that $1 isn’t worth $1. (a)
Yet that view would seem to contradict the "low investment premium" which this article seems to support and explains as an accounting error.
This crudely calculated result is consistent with the academic finding that corporations who favor real investment over the return of capital have historically generated lower returns for shareholders. The finding appears to extend to the macroeconomic level as well–shareholders in the larger economy got a much bigger bang for their buck when cash was returned to them as dividends than when it was deployed into capital expenditure.

We should mention that an alternative way to explain the result, likely to be favored by bearish investors, would be to argue that earnings have historically been overstated. The argument would be that a significant portion of the earnings retained by the corporate sector across history was actually spent on maintaining capital and output capacity in their current states, as opposed to being “invested” in new projects to grow them
Not sure what to make of this.

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

3funder
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Re: philosophicaleconomics predicts 4% real equity returns

Post by 3funder » Sat Feb 17, 2018 7:31 am

whodidntante wrote:
Wed Feb 14, 2018 1:45 pm
I'll take mine as a gut wrenching market crash that then trades sideways for years and years. Then a violently raging bull as I approach retirement. With continuously fantastic career outcomes for me. K thx.
Yes!

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HomerJ
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Re: philosophicaleconomics predicts 4% real equity returns

Post by HomerJ » Sat Feb 17, 2018 10:24 am

WanderingDoc wrote:
Sat Feb 17, 2018 2:15 am
I know that my real estate investments will outperform equities all day every day even on its worst year
Ah, I remember being young once.

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willthrill81
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Re: philosophicaleconomics predicts 4% real equity returns

Post by willthrill81 » Sat Feb 17, 2018 10:51 am

siamond wrote:
Fri Feb 16, 2018 11:42 pm
willthrill81 wrote:
Fri Feb 16, 2018 11:11 am
However, I'm not sure that I buy the real return argument, even though CAPE has had stronger correlations with real returns than nominal. I'm not aware of anyone who has identified how CAPE should have anything to do with inflation, and a real return is merely a nominal one less inflation. There is no logical reason why CAPE should be a better predictor of nominal returns and inflation than just nominal returns. Consequently, I currently chalk this one up to coincidence.
Er, I'm afraid you got this backwards. CAPE has nothing to do with inflation (because the inflation factor in the denominator and the numerator cancel each other), therefore there is no logical reason why 1/CAPE should be a better predictor of nominal returns than of real returns, given the extremely random nature of (past) inflation.
I always thought that nominal returns had less 'information' than real returns, not more. It seems 'easier' to estimate nominal returns because 'visible' returns are always nominal, never real. But I'm willing to learn the error of my thinking.
siamond wrote:
Fri Feb 16, 2018 11:42 pm
From an empirical standpoint, when you look at the track record (yeah, I ran all this math in depth, among numerous other people), it is plainly obvious as the average of 1/CAPE (for a given starting year) is indeed very close to the average realized real returns over a decade or more (following this starting year), for the known history.
The graph I posted above from Kitces indicates that CAPE doesn't reach its peak predictive power for real returns until 18 years out, not 10.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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willthrill81
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Re: philosophicaleconomics predicts 4% real equity returns

Post by willthrill81 » Sat Feb 17, 2018 10:56 am

JBTX wrote:
Sat Feb 17, 2018 1:44 am
Yes that thought actually occurred to me. It forces the uncomfortable conclusion that 3% real for a 60/40’portfolio may be too high. Perhaps 2% real, but that just seems so low and almost on the verge of pointless from an investing perspective. Maybe 2.5%. I’m going to have to ponder this. Maybe a case of the numbers being what they are and I just don’t want to accept the answer.
2% real? I'd seriously beef up my currently humble peer-to-peer lending investments long before I settled for that. My returns have declined in the last couple of years but are still around 7.5% nominal. Real estate crowdfunding would be another 'alternative' investment I'd look into; the White Coat Investor is one of many that have had success in this area.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

wesgreen
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Re: philosophicaleconomics predicts 4% real equity returns

Post by wesgreen » Sat Feb 17, 2018 11:04 am

getrichslowly wrote:
Wed Feb 14, 2018 12:10 pm
Future U.S. Equity Returns: A Best-Case Upper Limit
Posted on January 15, 2018 by philosophicalecon@gmail.com
http://www.philosophicaleconomics.com/2 ... per-limit/

I find this article highly fascinating. It confirms a hunch I've had all along that inflated CAPE must imply lower future returns. RIP 4%-SWR.
That's right - hello 5% SWR!

JBTX
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Re: philosophicaleconomics predicts 4% real equity returns

Post by JBTX » Sat Feb 17, 2018 11:08 am

willthrill81 wrote:
Sat Feb 17, 2018 10:56 am
JBTX wrote:
Sat Feb 17, 2018 1:44 am
Yes that thought actually occurred to me. It forces the uncomfortable conclusion that 3% real for a 60/40’portfolio may be too high. Perhaps 2% real, but that just seems so low and almost on the verge of pointless from an investing perspective. Maybe 2.5%. I’m going to have to ponder this. Maybe a case of the numbers being what they are and I just don’t want to accept the answer.
2% real? I'd seriously beef up my currently humble peer-to-peer lending investments long before I settled for that. My returns have declined in the last couple of years but are still around 7.5% nominal. Real estate crowdfunding would be another 'alternative' investment I'd look into; the White Coat Investor is one of many that have had success in this area.
I agree that isn’t much to get excited about but the numbers are what they are. I may decide to tweak my portfolio with a bit more international and bit more EM tilt. Also possibly small cap value tilt

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siamond
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Re: philosophicaleconomics predicts 4% real equity returns

Post by siamond » Sat Feb 17, 2018 12:23 pm

willthrill81 wrote:
Sat Feb 17, 2018 10:51 am
I always thought that nominal returns had less 'information' than real returns, not more. It seems 'easier' to estimate nominal returns because 'visible' returns are always nominal, never real. But I'm willing to learn the error of my thinking. [...]
The graph I posted above from Kitces indicates that CAPE doesn't reach its peak predictive power for real returns until 18 years out, not 10.
I made a simplified statement by saying "a decade or more". I don't know how Kitces proceeded exactly, but the best procedure ihmo is, for a given starting year, to take the realized return after 10 years, then the realized return after 11 years, etc, the realized return after 19 years, and average them (then generalize the model to a range of future years). Then you can compare to an expected return model (1/CAPE or else) with less 'noise' due to valuation vagaries - it's a way to isolate the 'signal' if you wish. Not my idea, I read it in another article from Philosophical Economics, and this made a lot of sense. An expected return model is highly probabilistic, so you want to try to isolate the center of the distribution.

For you to get a better feel about it, why don't you run the numbers yourself? Use CAPE and the S&P 500 historical returns and the inflation from Multpl.com, and it only requires a very simple spreadsheet to figure it out. But again... correlation is just one aspect of thing... it is really important to also look at absolute values (e.g. the average across all starting years) and amplitude (a metric like RMSE does a good job with that). Only the last 2 metrics will demonstrate the 'real' aspect of the 1/CAPE model.

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Frugal Al
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Re: philosophicaleconomics predicts 4% real equity returns

Post by Frugal Al » Sat Feb 17, 2018 12:27 pm

The 4% SWR will work even with a consistent 1.5% real rate of return. The problem is the sequence of returns. Although the article is interesting, in and of itself, it in no way dispels the 4% SWR.

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willthrill81
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Re: philosophicaleconomics predicts 4% real equity returns

Post by willthrill81 » Sat Feb 17, 2018 1:11 pm

siamond wrote:
Sat Feb 17, 2018 12:23 pm
For you to get a better feel about it, why don't you run the numbers yourself? Use CAPE and the S&P 500 historical returns and the inflation from Multpl.com, and it only requires a very simple spreadsheet to figure it out. But again... correlation is just one aspect of thing... it is really important to also look at absolute values (e.g. the average across all starting years) and amplitude (a metric like RMSE does a good job with that). Only the last 2 metrics will demonstrate the 'real' aspect of the 1/CAPE model.
Across the full spectrum of time horizons, the correlation just isn’t very strong. That’s because valuations aren’t reliably mean-reverting. There’s too much valuation variability in the historical data set, even when we use “Shillerized” averages over 10 year time spans. For the correlation to get tight, the growth and dividend errors have to superficially cancel with the valuation errors–but that doesn’t consistently happen, hence the breakdown.

Now, to be clear, I’m not saying that valuation doesn’t matter. Valuation definitely matters–its power as a return factor has been demonstrated in stock markets all over the world. Holding other factors constant, if you buy cheap, you’ll do better, on average, than if you buy expensive. This is true whether we’re talking about individual stocks, or the aggregate market.

What I’m taking issue with is the notion that we can use valuation to build “historically reliable” prediction models whose specific predictions closely align with actual past results, models that give us warrant to attach special “scientific” or “empirical” privilege to our bullish or bearish opinions. That, we cannot do. Given the significant variability in the historical data set, the best we can do is mine curve-fits whose errors conveniently offset and whose deviations conveniently disappear. These are not worth the effort.

In the end, valuation metrics are only capable of giving us a crude idea of what future returns will be. In the present context, they can tell us what we already know and accept: that future real returns will be less than the 6% historical average (a perfectly appropriate outcome that we should expect at equilibrium, given the secular decline in interest rates and the below-average implied returns on the assets that most directly compete with equities: cash and bonds). But they can’t tell us much more. They can’t arbitrate the debate between those of us who expect, say, 3% real returns for U.S. equities going forward, and who therefore judge the market to be fairly valued (relative to cash at a likely negative long-term real return), and those of us who expect negative real returns for equities, and who therefore find the market to be egregiously overvalued. The reason valuations can’t arbitrate that debate is that they don’t reliably mean-revert. If they did, we wouldn’t be having this discussion.
http://www.philosophicaleconomics.com/2 ... ixpercent/

To put it simply, valuations matter, but there are too many other factors at work for them to be a reliable predictor of the future. Others have gone down this path and found the exercise to be a futile one.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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grayfox
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Re: philosophicaleconomics predicts 4% real equity returns

Post by grayfox » Sat Feb 17, 2018 1:23 pm

The problem with Nominal measurements is that they are made with a yardstick that grow and shrinks.

Suppose you measure the length of a football field one year and it measures 100.0 yards.
One year later you measure the field again and it measures 105.0 yards.
The Nominal length of the field grew by 5%. Did the Real length of the field grow by 5%?

No. The growth was an illusion. It was only the yardstick that shrunk.
To get the Real length, you have to know how much the yardstick shrunk and back that out.
In this example, if you know that the yardstick shrunk to 100/105 = 0.95238 yards, then the Real length is still 100.0 yards

To get the Real length, you have to deflate the Nominal measurement by the amount the yardstick shrunk.

When making measurements its good if the yardstick doesn't change. E.g. 1 meter was once defined as the distance between two marks on a bar made from 90% platinum / 10% iridium alloy. That was very stable. But in 1960, they change the definition to

"The metre is the length equal to 1 650 763.73 wavelengths in vacuum of the radiation corresponding to the transition between the levels 2p10 and 5d5 of the krypton 86 atom."

https://en.wikipedia.org/wiki/History_of_the_metre
Last edited by grayfox on Sat Feb 17, 2018 1:52 pm, edited 1 time in total.

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siamond
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Re: philosophicaleconomics predicts 4% real equity returns

Post by siamond » Sat Feb 17, 2018 1:25 pm

willthrill81 wrote:
Sat Feb 17, 2018 1:11 pm
siamond wrote:
Sat Feb 17, 2018 12:23 pm
For you to get a better feel about it, why don't you run the numbers yourself? Use CAPE and the S&P 500 historical returns and the inflation from Multpl.com, and it only requires a very simple spreadsheet to figure it out. But again... correlation is just one aspect of thing... it is really important to also look at absolute values (e.g. the average across all starting years) and amplitude (a metric like RMSE does a good job with that). Only the last 2 metrics will demonstrate the 'real' aspect of the 1/CAPE model.
Across the full spectrum of time horizons, the correlation just isn’t very strong. That’s because valuations aren’t reliably mean-reverting. There’s too much valuation variability in the historical data set, even when we use “Shillerized” averages over 10 year time spans. For the correlation to get tight, the growth and dividend errors have to superficially cancel with the valuation errors–but that doesn’t consistently happen, hence the breakdown.

Now, to be clear, I’m not saying that valuation doesn’t matter. Valuation definitely matters–its power as a return factor has been demonstrated in stock markets all over the world. Holding other factors constant, if you buy cheap, you’ll do better, on average, than if you buy expensive. This is true whether we’re talking about individual stocks, or the aggregate market.

What I’m taking issue with is the notion that we can use valuation to build “historically reliable” prediction models whose specific predictions closely align with actual past results, models that give us warrant to attach special “scientific” or “empirical” privilege to our bullish or bearish opinions. That, we cannot do. Given the significant variability in the historical data set, the best we can do is mine curve-fits whose errors conveniently offset and whose deviations conveniently disappear. These are not worth the effort.

In the end, valuation metrics are only capable of giving us a crude idea of what future returns will be. In the present context, they can tell us what we already know and accept: that future real returns will be less than the 6% historical average (a perfectly appropriate outcome that we should expect at equilibrium, given the secular decline in interest rates and the below-average implied returns on the assets that most directly compete with equities: cash and bonds). But they can’t tell us much more. They can’t arbitrate the debate between those of us who expect, say, 3% real returns for U.S. equities going forward, and who therefore judge the market to be fairly valued (relative to cash at a likely negative long-term real return), and those of us who expect negative real returns for equities, and who therefore find the market to be egregiously overvalued. The reason valuations can’t arbitrate that debate is that they don’t reliably mean-revert. If they did, we wouldn’t be having this discussion.
http://www.philosophicaleconomics.com/2 ... ixpercent/

To put it simply, valuations matter, but there are too many other factors at work for them to be a reliable predictor of the future. Others have gone down this path and found the exercise to be a futile one.
LOL. I am keenly aware of this write-up, this is exactly the one where the idea of using a range of future years to look at came from. Philosophical Economics is indeed an absolutely remarkable writer. Now you have to parse his words carefully. As you emphasized, he stated that valuation metrics are only capable of giving us a crude idea of what future returns will be. This does NOT mean that this is a futile exercise, far from it.

Valuations are definitely useful for mid-term financial planning. And one can devise interesting ways to use them in combination with variable withdrawal methods. None of that requires a precise prediction or a strict return to the mean. None of that requires short-term predictions (aka market timing or TAA). This is the point valuation naysayers keep missing. A crude tool is well, crude, but this doesn't mean it's useless. Things are never black & white in finance. Again, I would encourage you to play with the numbers yourself.

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Re: philosophicaleconomics predicts 4% real equity returns

Post by willthrill81 » Sat Feb 17, 2018 1:32 pm

siamond wrote:
Sat Feb 17, 2018 1:25 pm
Valuations are definitely useful for mid-term financial planning. And one can devise interesting ways to use them in combination with variable withdrawal methods. None of that requires a precise prediction or a strict return to the mean. None of that requires short-term predictions (aka market timing or TAA). This is the point valuation naysayers keep missing. A crude tool is well, crude, but this doesn't mean it's useless.
Image

This chart displays forward 10 year nominal returns at varying categorical levels of CAPE.

When CAPE was above 20, subsequent 10 year returns ranged from -1.38% to 12.07%. Eight of the 18 periods in that category had nominal returns above 7%, while four of them had negative returns. How is this useful as a mid-term financial planning tool with that much variation in expectations? Just looking at that graph, it seems that CAPE has been a better predictor of really good returns than marginal ones.

I don't need a mid-term prediction of stock returns. And being a trend follower, my returns may be quite different those of a buy-and-hold approach.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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Re: philosophicaleconomics predicts 4% real equity returns

Post by WanderingDoc » Sat Feb 17, 2018 1:44 pm

HomerJ wrote:
Sat Feb 17, 2018 10:24 am
WanderingDoc wrote:
Sat Feb 17, 2018 2:15 am
I know that my real estate investments will outperform equities all day every day even on its worst year
Ah, I remember being young once.
I KNOW my real estate holdings will outpeform the predicted 2.5% mutual funds return. Or 4%. or 6%. KNOW :beer
Assuming there is a year with 0% appreciation (possible) and 0% cash flow (not possible because I buy cash-flowing deals, but lets assume), I will earn more than 6% on net tax benefits and principal paydown ALONE. Yup, thats right. No two ways about it.
Don't wait to buy real estate. Buy real estate, and wait. | Rent where you live, buy where others pay your mortgage for you.

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siamond
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Re: philosophicaleconomics predicts 4% real equity returns

Post by siamond » Sat Feb 17, 2018 1:59 pm

willthrill81 wrote:
Sat Feb 17, 2018 1:32 pm
siamond wrote:
Sat Feb 17, 2018 1:25 pm
Valuations are definitely useful for mid-term financial planning. And one can devise interesting ways to use them in combination with variable withdrawal methods. None of that requires a precise prediction or a strict return to the mean. None of that requires short-term predictions (aka market timing or TAA). This is the point valuation naysayers keep missing. A crude tool is well, crude, but this doesn't mean it's useless.
Image

This chart displays forward 10 year nominal returns at varying categorical levels of CAPE.

When CAPE was above 20, subsequent 10 year returns ranged from -1.38% to 12.07%. Eight of the 18 periods in that category had nominal returns above 7%, while four of them had negative returns. How is this useful as a mid-term financial planning tool with that much variation in expectations? Just looking at that graph, it seems that CAPE has been a better predictor of really good returns than marginal ones.

I don't need a mid-term prediction of stock returns. And being a trend follower, my returns may be quite different those of a buy-and-hold approach.
So you quoted extremely blunt math (instead of the one I suggested) on already blunt numbers, and yeah, you find something very blurry. No surprise. It does remain blurry when using better math, mind you. Oh well, we can re-discuss the whole topic when you get closer to retirement. Then you may start to better appreciate the value of mid-term financial planning and more subtle withdrawal methods. I wish you luck in any case.

Yes, agreed, those valuation methods are in the context of a buy-and-old strategy, it is quite doubtful that they would display meaningful predictive value of momentum strategies. That's a good point.

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Re: philosophicaleconomics predicts 4% real equity returns

Post by marcopolo » Sat Feb 17, 2018 2:05 pm

willthrill81 wrote:
Sat Feb 17, 2018 1:32 pm
siamond wrote:
Sat Feb 17, 2018 1:25 pm
Valuations are definitely useful for mid-term financial planning. And one can devise interesting ways to use them in combination with variable withdrawal methods. None of that requires a precise prediction or a strict return to the mean. None of that requires short-term predictions (aka market timing or TAA). This is the point valuation naysayers keep missing. A crude tool is well, crude, but this doesn't mean it's useless.
Image

This chart displays forward 10 year nominal returns at varying categorical levels of CAPE.

When CAPE was above 20, subsequent 10 year returns ranged from -1.38% to 12.07%. Eight of the 18 periods in that category had nominal returns above 7%, while four of them had negative returns. How is this useful as a mid-term financial planning tool with that much variation in expectations? Just looking at that graph, it seems that CAPE has been a better predictor of really good returns than marginal ones.

I don't need a mid-term prediction of stock returns. And being a trend follower, my returns may be quite different those of a buy-and-hold approach.
I look at this plot and come to very somewhat conclusion (i think). It shows that CAPE is actually a pretty good metric to predict "modest" vs "good" returns.
If you consider CAPE < 15 and CAPE > 20, and ask the question, will my return 10 years form now be less than or greater than 10%, it looks like a pretty good metric. The CAPE 15-20 does seems to straddle the two other distributions.

No metric is perfect, but the plot really does look like two (nearly Gaussian) distribution plots with clearly different means, and some spread associated with it. This is exactly what you would expect. It is a extremely rare phenomenon to have a metric where the tails of the distribution do not overlap to some degree. It would be nice, but wholly unrealistic. It seem you are pointing to individual outcomes where the tails cross into the other category, and saying because of that, the metric has had no predictive power, this is simply not true. The means appear to be well separated, and the std dev, while large, still seems to separate the two categories quite well. It would be useful to know what the Mahalanobis distance is between these to categories.

How is this practically useful? Well, this says that when CAPE is >20, you are much more likely (not guaranteed) to have lower returns in 10 years than if you are starting with CAPE < 15, based on historical data. So, you might want to plan accordingly. I am not sure it changes AA, but it may change your retirement planning assumptions. Maybe we are all saying the same thing, valuations matter.
Once in a while you get shown the light, in the strangest of places if you look at it right.

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Re: philosophicaleconomics predicts 4% real equity returns

Post by willthrill81 » Sat Feb 17, 2018 2:10 pm

siamond wrote:
Sat Feb 17, 2018 1:59 pm
So you quoted extremely blunt math (instead of the one I suggested) on already blunt numbers, and yeah, you find something very blurry. No surprise. It does remain blurry when using better math, mind you. Oh well, we can re-discuss the whole topic when you get closer to retirement. Then you may start to better appreciate the value of mid-term financial planning and more subtle withdrawal methods.
Kitces found back in 2008 that there was a strong relationship (correlation of .91) between CAPE and the SWR for a 60/40 portfolio for the following 30 years. I'd call that practical, actionable, and useful.
Notably, that means that starting market valuation shows an even stronger relationship to safe withdrawal rates than it does to the 15-year
real returns of the portfolio itself!
Image

Granted, we're at the upper end of the top quintile of valuations, so I wouldn't recommend that people start with more than 4% WR in the current environment, even though it would not be unprecedented to see a 6% WR work in a similar situation.
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Re: philosophicaleconomics predicts 4% real equity returns

Post by willthrill81 » Sat Feb 17, 2018 2:18 pm

marcopolo wrote:
Sat Feb 17, 2018 2:05 pm
It seem you are pointing to individual outcomes where the tails cross into the other category, and saying because of that, the metric has had no predictive power, this is simply not true.
On the contrary, I've never said that CAPE or any other valuation metric has no predictive power. Statistically speaking, they absolutely do. But there is a big difference between statistical significance and practical significance. I'd say that the practical significance of an approach with as wide of a range of possibilities as CAPE is limited, but that's a matter of opinion.
marcopolo wrote:
Sat Feb 17, 2018 2:05 pm
How is this practically useful? Well, this says that when CAPE is >20, you are much more likely (not guaranteed) to have lower returns in 10 years than if you are starting with CAPE < 15, based on historical data. So, you might want to plan accordingly. I am not sure it changes AA, but it may change your retirement planning assumptions. Maybe we are all saying the same thing, valuations matter.
As I've posted in this thread, I'm using 5% real as my planning metric, but even if I experience 3% real returns, it will only push back my planned retirement from age 50 to 52.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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Re: philosophicaleconomics predicts 4% real equity returns

Post by siamond » Sat Feb 17, 2018 2:30 pm

willthrill81 wrote:
Sat Feb 17, 2018 2:10 pm
siamond wrote:
Sat Feb 17, 2018 1:59 pm
So you quoted extremely blunt math (instead of the one I suggested) on already blunt numbers, and yeah, you find something very blurry. No surprise. It does remain blurry when using better math, mind you. Oh well, we can re-discuss the whole topic when you get closer to retirement. Then you may start to better appreciate the value of mid-term financial planning and more subtle withdrawal methods.
Kitces found back in 2008 that there was a strong relationship (correlation of .91) between CAPE and the SWR for a 60/40 portfolio for the following 30 years. I'd call that practical, actionable, and useful.
This is a really good point. Most writers focus on the relationship between expected returns models (CAPE-based or else) and future actual returns. Few writers look at the (much more useful, indeed) relationship between expected returns and withdrawal methods, and yes, the SWR metric, when used on individual cycles, is -somewhat counter-intuitively- a good proxy for that, and easy to compute. When I modeled those things, I went straight to actual variable methods, but this is harder for people to quickly grasp. I'm going to redo (and extend) Kitces CAPE/SWR math, and publish the results. Thanks for the pointer.

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Re: philosophicaleconomics predicts 4% real equity returns

Post by willthrill81 » Sat Feb 17, 2018 2:39 pm

siamond wrote:
Sat Feb 17, 2018 2:30 pm
willthrill81 wrote:
Sat Feb 17, 2018 2:10 pm
siamond wrote:
Sat Feb 17, 2018 1:59 pm
So you quoted extremely blunt math (instead of the one I suggested) on already blunt numbers, and yeah, you find something very blurry. No surprise. It does remain blurry when using better math, mind you. Oh well, we can re-discuss the whole topic when you get closer to retirement. Then you may start to better appreciate the value of mid-term financial planning and more subtle withdrawal methods.
Kitces found back in 2008 that there was a strong relationship (correlation of .91) between CAPE and the SWR for a 60/40 portfolio for the following 30 years. I'd call that practical, actionable, and useful.
This is a really good point. Most writers focus on the relationship between expected returns models (CAPE-based or else) and future actual returns. Few writers look at the (much more useful, indeed) relationship between expected returns and withdrawal methods, and yes, the SWR metric, when used on individual cycles, is -somewhat counter-intuitively- a good proxy for that, and easy to compute. When I modeled those things, I went straight to actual variable methods, but this is harder for people to quickly grasp. I'm going to redo (and extend) Kitces CAPE/SWR math, and publish the results. Thanks for the pointer.
:sharebeer

I'd be very interested to see an update of Kitces' now decade-old work.
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Re: philosophicaleconomics predicts 4% real equity returns

Post by siamond » Sat Feb 17, 2018 8:07 pm

willthrill81 wrote:
Sat Feb 17, 2018 2:39 pm
Kitces found back in 2008 that there was a strong relationship (correlation of .91) between CAPE and the SWR for a 60/40 portfolio for the following 30 years. I'd call that practical, actionable, and useful.
I just browsed through the paper, which seems indeed well researched and well written (as usual with Kitces). I'll try to reproduce some of his findings (e.g. figure 7 + correlation math), then extend to more recent years, and then take a slightly different approach as I have limited trust in the CAPE quintile breakdown (which would have varied over history, today's breakdown isn't the same as it was 30 years, as a case in point). I was a bit baffled by the 0.91 figure you quoted, and yeah, there was a bit of a typo here, let me quote the author:

In fact, over the past 140+ years, the safe withdrawal rate for a 30-year retirement period has shown a whopping 0.91 correlation to the annualized real return of the portfolio over the first 15 years of the time period!

Figure 5 shows that in reality, the starting P/E ratio has an incredibly strong inverse relationship to returns over the subsequent 15 years (the correlation of the data is actually -0.65).

In reviewing the results of Figure 6, a strong relationship becomes evident between initial market valuation and subsequent safe withdrawal rates for a balanced portfolio. In fact, the correlation between them is -0.74.

Ok, that makes more sense. Also note that he's speaking of correlation here, not of the more commonly used "R2" metric (correlation to the power of two). But still, those definitely remain significant numbers, and I'll play around with this kind of analysis. Thanks again for the pointer, I had not read this article before.

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Re: philosophicaleconomics predicts 4% real equity returns

Post by getrichslowly » Tue Feb 20, 2018 11:33 am

willthrill81 wrote:
Sat Feb 17, 2018 2:10 pm
siamond wrote:
Sat Feb 17, 2018 1:59 pm
So you quoted extremely blunt math (instead of the one I suggested) on already blunt numbers, and yeah, you find something very blurry. No surprise. It does remain blurry when using better math, mind you. Oh well, we can re-discuss the whole topic when you get closer to retirement. Then you may start to better appreciate the value of mid-term financial planning and more subtle withdrawal methods.
Kitces found back in 2008 that there was a strong relationship (correlation of .91) between CAPE and the SWR for a 60/40 portfolio for the following 30 years. I'd call that practical, actionable, and useful.
Notably, that means that starting market valuation shows an even stronger relationship to safe withdrawal rates than it does to the 15-year
real returns of the portfolio itself!
Image

Granted, we're at the upper end of the top quintile of valuations, so I wouldn't recommend that people start with more than 4% WR in the current environment, even though it would not be unprecedented to see a 6% WR work in a similar situation.
The only problem here is that the min SWR of 4.4% was over a period when bond returns were generous enough to support the SWR. We currently have simultaneously low (relative to historical average) equity and bond yields. So actual this should be a multivariate correlation on both yield variables. I think if you ran that correlation you might find that today's valuations suggest an even lower SWR than even 4.4%. Also, historically, there has been a strong inverse relationship between equity and bond returns. For example, during the 2007 recession, long term treasures exploded. That was probably just luck, and not necessarily guaranteed to repeat. It is also possible we get hit with a recession that causes both stocks AND bonds to return a negative sequence of returns. In that event, even a diversified 60/40 portfolio will not do well. The 40% in bonds will absorb the shock but after a decade you could deplete enough capital to make your retirement strategy questionable.

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Re: philosophicaleconomics predicts 4% real equity returns

Post by itstoomuch » Tue Feb 20, 2018 11:50 am

getrichslowly wrote:It is also possible we get hit with a recession that causes both stocks AND bonds to return a negative sequence of returns. In that event, even a diversified 60/40 portfolio will not do well. The 40% in bonds will absorb the shock but after a decade you could deplete enough capital to make your retirement strategy questionable.
+1
needed to be repeated, IMO.
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Re: philosophicaleconomics predicts 4% real equity returns

Post by lazyday » Tue Feb 20, 2018 12:01 pm

siamond wrote:
Fri Feb 16, 2018 11:42 pm
There is also a more mathematical explanation of why 1/CAPE makes sense as an expected (real) returns model, but this will be for another post...
Just making sure you've already seen this version:
Appendix A: The Relation Between Earnings Yield and Equity Expected Returns
We present here the theoretical justification behind using earnings yield to proxy for equity expected returns.
Start with the Gordon growth model:
E(r) = DY + g
https://www.aqr.com/library/aqr-publica ... et-classes click "Appendix"

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Re: philosophicaleconomics predicts 4% real equity returns

Post by willthrill81 » Tue Feb 20, 2018 12:26 pm

getrichslowly wrote:
Tue Feb 20, 2018 11:33 am
willthrill81 wrote:
Sat Feb 17, 2018 2:10 pm
siamond wrote:
Sat Feb 17, 2018 1:59 pm
So you quoted extremely blunt math (instead of the one I suggested) on already blunt numbers, and yeah, you find something very blurry. No surprise. It does remain blurry when using better math, mind you. Oh well, we can re-discuss the whole topic when you get closer to retirement. Then you may start to better appreciate the value of mid-term financial planning and more subtle withdrawal methods.
Kitces found back in 2008 that there was a strong relationship (correlation of .91) between CAPE and the SWR for a 60/40 portfolio for the following 30 years. I'd call that practical, actionable, and useful.
Notably, that means that starting market valuation shows an even stronger relationship to safe withdrawal rates than it does to the 15-year
real returns of the portfolio itself!
Image

Granted, we're at the upper end of the top quintile of valuations, so I wouldn't recommend that people start with more than 4% WR in the current environment, even though it would not be unprecedented to see a 6% WR work in a similar situation.
The only problem here is that the min SWR of 4.4% was over a period when bond returns were generous enough to support the SWR. We currently have simultaneously low (relative to historical average) equity and bond yields. So actual this should be a multivariate correlation on both yield variables. I think if you ran that correlation you might find that today's valuations suggest an even lower SWR than even 4.4%. Also, historically, there has been a strong inverse relationship between equity and bond returns.
Historically, there is actually a very weak negative (inverse) relationship between equities and bonds, but this relationship has changed from positive to negative at many points along the way historically.
getrichslowly wrote:
Tue Feb 20, 2018 11:33 am
For example, during the 2007 recession, long term treasures exploded. That was probably just luck, and not necessarily guaranteed to repeat.
Actually, that move made a lot of sense and was not unprecedented. When there is a lot of turbulence in equities, there is usually a 'flight to safety' that boosts bonds, but this is not guaranteed (nothing is).
getrichslowly wrote:
Tue Feb 20, 2018 11:33 am
It is also possible we get hit with a recession that causes both stocks AND bonds to return a negative sequence of returns. In that event, even a diversified 60/40 portfolio will not do well. The 40% in bonds will absorb the shock but after a decade you could deplete enough capital to make your retirement strategy questionable.
Retirees from 1966 encountered just that scenario, yet still made it with the '4% rule' (actually around 3.9%). That being said, no one is actually the '4% rule' as it is put forth in this research; everyone is making adjustments to their withdrawals based on the performance of their portfolio.

And the '4% rule' is not a "retirement strategy." It's only an approximation used for planning purposes.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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Re: philosophicaleconomics predicts 4% real equity returns

Post by Jeff Albertson » Wed Feb 21, 2018 10:57 am

FWIW, the Economist's Philip Coggan also estimates 4% real, 6% nominal, at most (assumes there is no valuation downgrade for equities).
https://www.economist.com/blogs/buttonw ... -investing
The current dividend yield on the global market is around 2.5%. It seems unwise to assume any further valuation improvement (a rise in the price/dividend ratio or fall in the dividend yield). The academics allow a fairly generous 1% for future real dividend growth to come up with a current ex ante equity risk premium of 3.5%. If that seems low, we should note that the academics made the same forecast in 2000; since then, the equity risk premium has been...3.4%.

To estimate a total return, one must of course add the risk premium to the risk-free rate. And that is the second problem for the optimists. Real rates are negative across the world; ie short-term rates are below the rate of inflation. Even if we take a longer rate (10-year inflation-linked bonds, for example), the US has a positive real rate of just 0.5%. Adding a risk premium of 3.5% to that gets you a real return of 4%. If we assume inflation of 2%, then the nominal return from equities would be 6%. And all this assumes there is no valuation downgrade for equities, as seems quite plausible.

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Re: philosophicaleconomics predicts 4% real equity returns

Post by HomerJ » Mon Feb 26, 2018 2:51 am

siamond wrote:
Sat Feb 17, 2018 2:30 pm
willthrill81 wrote:
Sat Feb 17, 2018 2:10 pm
siamond wrote:
Sat Feb 17, 2018 1:59 pm
So you quoted extremely blunt math (instead of the one I suggested) on already blunt numbers, and yeah, you find something very blurry. No surprise. It does remain blurry when using better math, mind you. Oh well, we can re-discuss the whole topic when you get closer to retirement. Then you may start to better appreciate the value of mid-term financial planning and more subtle withdrawal methods.
Kitces found back in 2008 that there was a strong relationship (correlation of .91) between CAPE and the SWR for a 60/40 portfolio for the following 30 years. I'd call that practical, actionable, and useful.
This is a really good point. Most writers focus on the relationship between expected returns models (CAPE-based or else) and future actual returns. Few writers look at the (much more useful, indeed) relationship between expected returns and withdrawal methods, and yes, the SWR metric, when used on individual cycles, is -somewhat counter-intuitively- a good proxy for that, and easy to compute. When I modeled those things, I went straight to actual variable methods, but this is harder for people to quickly grasp. I'm going to redo (and extend) Kitces CAPE/SWR math, and publish the results. Thanks for the pointer.
So apparently, neither of you read my previous post....

Here's an article from the same site from 2014, debunking valuations as a prediction tool.

http://www.philosophicaleconomics.com/2 ... ixpercent/
In this piece, I’m going to present and explain a simple, easy-to-understand method of forecasting stock market returns on the basis of valuation. I’m then going to insert the popular Shiller CAPE into the method to assess how well the historical predictions fit with the actual historical results. As you can see in the chart below, they fit almost perfectly, across 133 years of available data (no arbitrary exclusions). The correlation coefficient is a fantastic 0.92.

After presenting the chart, I’m going to demonstrate that its tight correlation is an illusion. I’m going to carefully flesh out its subtle trick, a trick that is ultimately hidden in every chart that purports to use valuation to accurately predict returns in historical data. Such a feat cannot be accomplished–the historical data will not allow it.

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Re: philosophicaleconomics predicts 4% real equity returns

Post by rgs92 » Mon Feb 26, 2018 2:59 am

I was thinking that even 0% real return was respectable. At least you are keeping up with inflation, not something that is easy to do.

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Re: philosophicaleconomics predicts 4% real equity returns

Post by HomerJ » Mon Feb 26, 2018 3:02 am

WanderingDoc wrote:
Sat Feb 17, 2018 1:44 pm
HomerJ wrote:
Sat Feb 17, 2018 10:24 am
WanderingDoc wrote:
Sat Feb 17, 2018 2:15 am
I know that my real estate investments will outperform equities all day every day even on its worst year
Ah, I remember being young once.
I KNOW my real estate holdings will outpeform the predicted 2.5% mutual funds return. Or 4%. or 6%. KNOW :beer
Assuming there is a year with 0% appreciation (possible) and 0% cash flow (not possible because I buy cash-flowing deals, but lets assume), I will earn more than 6% on net tax benefits and principal paydown ALONE. Yup, thats right. No two ways about it.
(1) Do you actually believe that annual equity returns are limited to what is predicted? Are you actually stating that 6% a year is the max equities will ever return in a single year? Afer they gained 25% just last year?
(2) Do you actually believe that real estate's worst possible year is 0% appreciation? That's your "worst case"?

How can you possibly state that your real estate will always out-perform equities, even in real estate's worst year? That sounds like a year-to-year comparison. Did you mean something else? I was responding to what you wrote. It's nonsensical. Maybe I misunderstood. Equities could easily go up 10%, 20%, even 50% in a single year, and real estate could drop in value 10%, 20%, even 50% in a single year.

All of those things have happened in the past. Even the RECENT past. You're young, and they haven't happened to you. Yet. But do you believe it's never happened? Do you believe it can never happen again?

I don't doubt you've done an excellent job investing in real estate. I don't doubt that you will become quite rich with your investments, over the long-run. But why must you make such silly, and obviously silly, statements like "real estate never goes down", etc.?
Last edited by HomerJ on Mon Feb 26, 2018 3:25 am, edited 1 time in total.

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Re: philosophicaleconomics predicts 4% real equity returns

Post by AlohaJoe » Mon Feb 26, 2018 3:15 am

siamond wrote:
Sat Feb 17, 2018 8:07 pm
Kitces said:
In fact, over the past 140+ years, the safe withdrawal rate for a 30-year retirement period has shown a whopping 0.91 correlation to the annualized real return of the portfolio over the first 15 years of the time period!
FWIW, I've come to have doubts that using "real returns" like this is as meaningful it appears. After all, there are two parts to real returns: nominal returns and inflation. I think it can be useful to try to decompose things and see the relative contributions of nominal returns and inflation. I've done two small analyses along these lines:

https://medium.com/@justusjp/misunderst ... 49d601a018

I found that inflation was more correlated with SWRs than nominal returns. Which makes a bit of sense: returns can go up and down, after a crash there's (usually) always a recovery. But the same doesn't hold for inflation. After the high inflation of the 1970s and 1980s there was no corresponding deflation (or even particularly low inflation) to balance it out.

This is the correlation of SWR to (nominal) equity returns over the first N-years of retirement

Image

And here's the correlation of SWR to inflation over the first N-years of retirement

Image

Inflation is the more gradual risk but (by looking at the total areas under the curves) it is clearly the significantly larger risk. And things like CAPE10 don't tell us anything about future inflation.

I looked at r-squared for real returns over the first N-years of retirement

Image

After thinking about it for a while I became more convinced that (nominal) equity returns are not that relevant to retirement. Well, that's not entirely true -- it would be more fair to say that (nominal) equity returns are dramatically over-rated in their impact on retirement and that inflation is a substantially bigger problem.

https://medium.com/@justusjp/sequence-o ... 7b613c9641

This is easiest to see by looking at nominal withdrawals using a somewhat realistic withdrawal strategy:

Image

Even in the worst stock crash in US history, the change in withdrawals just isn't as dramatic as most people have been led to believe. And if we look at every other significant crash in US history it is difficult to see significant hardship in withdrawals:

Here's 1966 -- "the worst year to retire" -- and had 2 crashes and bear markets in the first decade of retirement -- which you can't even really see in their withdrawals....

Image

Here's the most recent crashes...

Image
Image

What really turns a retirement bad is inflation. And CAPE doesn't tell us anything about future inflation.

Again, I'm not saying that equity returns are completely meaningless. And we should take steps to make our retirements as efficient as possible. But future equity returns seem to me like a 2nd or even 3rd rate impact compared to other forces -- like inflation and unplanned expenses.
Last edited by AlohaJoe on Mon Feb 26, 2018 10:50 am, edited 2 times in total.

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Re: philosophicaleconomics predicts 4% real equity returns

Post by HomerJ » Mon Feb 26, 2018 3:24 am

AlohaJoe wrote:
Mon Feb 26, 2018 3:15 am
But future equity returns seem to me like a 2nd or even 3rd rate impact compared to other forces -- like inflation and unplanned expenses.
This is because 4% is already conservative.

It's possible one could use low valuations to withdraw 5%-7% a year in retirement. But that would still be risky (less risky, sure, but the risk is never zero). So most of us stick with 4% anyway to start with, and adjust later if the good times do indeed show up.

Likewise, high valuations might indicate that 5%-7% is too risky, but, guess what, we were already going to use 4%.

So valuations make ZERO difference to our choice of retirement SWR. One could easily state that valuations don't matter.

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Re: philosophicaleconomics predicts 4% real equity returns

Post by AlohaJoe » Mon Feb 26, 2018 3:27 am

HomerJ wrote:
Mon Feb 26, 2018 3:24 am
AlohaJoe wrote:
Mon Feb 26, 2018 3:15 am
But future equity returns seem to me like a 2nd or even 3rd rate impact compared to other forces -- like inflation and unplanned expenses.
This is because 4% is already conservative.
Nothing in my analysis had anything to do with 4%, though. It was about calculating the Maximum Safe Withdrawal Rate (MSWR) for a given 30-year span and then comparing it to other things. At no point does what I wrote about assume 4% is being used.

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Re: philosophicaleconomics predicts 4% real equity returns

Post by HomerJ » Mon Feb 26, 2018 3:30 am

AlohaJoe wrote:
Mon Feb 26, 2018 3:27 am
HomerJ wrote:
Mon Feb 26, 2018 3:24 am
AlohaJoe wrote:
Mon Feb 26, 2018 3:15 am
But future equity returns seem to me like a 2nd or even 3rd rate impact compared to other forces -- like inflation and unplanned expenses.
This is because 4% is already conservative.
Nothing in my analysis had anything to do with 4%, though. It was about calculating the Maximum Safe Withdrawal Rate (MSWR) for a given 30-year span and then comparing it to other things. At no point does what I wrote about assume 4% is being used.
Ah, my apologies... I saw that the withdrawals were around the 4% range, and I misunderstood your point. Sorry about the derailment.

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Re: philosophicaleconomics predicts 4% real equity returns

Post by WanderingDoc » Mon Feb 26, 2018 3:44 am

HomerJ wrote:
Mon Feb 26, 2018 3:02 am
WanderingDoc wrote:
Sat Feb 17, 2018 1:44 pm
HomerJ wrote:
Sat Feb 17, 2018 10:24 am
WanderingDoc wrote:
Sat Feb 17, 2018 2:15 am
I know that my real estate investments will outperform equities all day every day even on its worst year
Ah, I remember being young once.
I KNOW my real estate holdings will outpeform the predicted 2.5% mutual funds return. Or 4%. or 6%. KNOW :beer
Assuming there is a year with 0% appreciation (possible) and 0% cash flow (not possible because I buy cash-flowing deals, but lets assume), I will earn more than 6% on net tax benefits and principal paydown ALONE. Yup, thats right. No two ways about it.
(1) Do you actually believe that annual equity returns are limited to what is predicted? Are you actually stating that 6% a year is the max equities will ever return in a single year? Afer they gained 25% just last year?
(2) Do you actually believe that real estate's worst possible year is 0% appreciation? That's your "worst case"?

How can you possibly state that your real estate will always out-perform equities, even in real estate's worst year? That sounds like a year-to-year comparison. Did you mean something else? I was responding to what you wrote. It's nonsensical. Maybe I misunderstood. Equities could easily go up 10%, 20%, even 50% in a single year, and real estate could drop in value 10%, 20%, even 50% in a single year.

All of those things have happened in the past. Even the RECENT past. You're young, and they haven't happened to you. Yet. But do you believe it's never happened? Do you believe it can never happen again?

I don't doubt you've done an excellent job investing in real estate. I don't doubt that you will become quite rich with your investments, over the long-run. But why must you make such silly, and obviously silly, statements like "real estate never goes down", etc.?
I didn't say real estate will never go down in capital value. What I AM saying is, if the equity markets tank and return -20% -30% -40%, a 2% dividend is nothing but a drop in the ocean and won't save you. However, if my real estate goes down in price, the checks in the mail and ACH deposits will continue to flow. I'm well diversified in real estate, across niches, strategies, and geographies.

Also, there are a few real estate deals where I have literally none or very little money in. On these, I will still make a return from rents, principal paydown by tenants, and generous tax liability offset, even if the values go to $0. Can't say the same for mutual funds. The best you can hope for is that all the smart minds are wrong about the 3% 4% 5% predicted real returns.
Don't wait to buy real estate. Buy real estate, and wait. | Rent where you live, buy where others pay your mortgage for you.

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Re: philosophicaleconomics predicts 4% real equity returns

Post by lazyday » Mon Feb 26, 2018 5:38 am

rgs92 wrote:
Mon Feb 26, 2018 2:59 am
I was thinking that even 0% real return was respectable. At least you are keeping up with inflation, not something that is easy to do.
But you're taking huge risks to get there! I want much more than 0% real for taking on equity risk. If my best guess for US equity is 0% over 10 years and 3% over 30 years, and I know that it could be worse than that, and can easily fall by 50% or more along the way, then I'm going to look for another asset class.

Also TIPS have positive real yield with much lower volatiltiy.

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Re: philosophicaleconomics predicts 4% real equity returns

Post by willthrill81 » Mon Feb 26, 2018 12:18 pm

lazyday wrote:
Mon Feb 26, 2018 5:38 am
rgs92 wrote:
Mon Feb 26, 2018 2:59 am
I was thinking that even 0% real return was respectable. At least you are keeping up with inflation, not something that is easy to do.
But you're taking huge risks to get there! I want much more than 0% real for taking on equity risk. If my best guess for US equity is 0% over 10 years and 3% over 30 years, and I know that it could be worse than that, and can easily fall by 50% or more along the way, then I'm going to look for another asset class.

Also TIPS have positive real yield with much lower volatiltiy.
With zero volatility, a 1.25% real return guarantees that the '4% rule' survives, but just barely. Current real yields on 30 year TIPS are 1.03%. Consequently, I think one could make a compelling argument for a retiree to hold all of their fixed income in 30 year TIPS.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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Re: philosophicaleconomics predicts 4% real equity returns

Post by lazyday » Mon Feb 26, 2018 1:05 pm

willthrill81 wrote:
Mon Feb 26, 2018 12:18 pm
With zero volatility, a 1.25% real return guarantees that the '4% rule' survives, but just barely. Current real yields on 30 year TIPS are 1.03%. Consequently, I think one could make a compelling argument for a retiree to hold all of their fixed income in 30 year TIPS.
Or a TIPS ladder.

The LMP (liability matching portfolio) concept seems to make a lot of sense today. Such as using TIPS to guarantee minimally acceptable spending each year, and equities for the rest.

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Re: philosophicaleconomics predicts 4% real equity returns

Post by siamond » Mon Feb 26, 2018 8:02 pm

AlohaJoe wrote:
Mon Feb 26, 2018 3:15 am
siamond wrote:
Sat Feb 17, 2018 8:07 pm
Kitces said:
In fact, over the past 140+ years, the safe withdrawal rate for a 30-year retirement period has shown a whopping 0.91 correlation to the annualized real return of the portfolio over the first 15 years of the time period!
FWIW, I've come to have doubts that using "real returns" like this is as meaningful it appears. After all, there are two parts to real returns: nominal returns and inflation. I think it can be useful to try to decompose things and see the relative contributions of nominal returns and inflation. I've done two small analyses along these lines:

https://medium.com/@justusjp/misunderst ... 49d601a018
I am confused. The quote from Kitces is (rightfully) about real returns. I just read your blog, you make a case that inflation is quite impactful (agreed), that drawdowns in nominal returns aren't that significant (agreed), and you conclude by:
So while the link between inflation and MSWR isn’t as strong as I initially suspected, I stand by my initial belief that worrying about a big (nominal) crash in the first few years of retirement is the wrong way to think about sequence of returns risk. Inflation is the bigger risk by a fair amount. Of course, the best thing is to look at both together: real equity returns.
So... why do you 'have doubts that using "real returns" like this is as meaningful it appears' ?

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Re: philosophicaleconomics predicts 4% real equity returns

Post by AlohaJoe » Mon Feb 26, 2018 9:41 pm

siamond wrote:
Mon Feb 26, 2018 8:02 pm
AlohaJoe wrote:
Mon Feb 26, 2018 3:15 am
siamond wrote:
Sat Feb 17, 2018 8:07 pm
Kitces said:
In fact, over the past 140+ years, the safe withdrawal rate for a 30-year retirement period has shown a whopping 0.91 correlation to the annualized real return of the portfolio over the first 15 years of the time period!
FWIW, I've come to have doubts that using "real returns" like this is as meaningful it appears. After all, there are two parts to real returns: nominal returns and inflation. I think it can be useful to try to decompose things and see the relative contributions of nominal returns and inflation. I've done two small analyses along these lines:

https://medium.com/@justusjp/misunderst ... 49d601a018
I am confused. The quote from Kitces is (rightfully) about real returns. I just read your blog, you make a case that inflation is quite impactful (agreed), that drawdowns in nominal returns aren't that significant (agreed), and you conclude by:
So while the link between inflation and MSWR isn’t as strong as I initially suspected, I stand by my initial belief that worrying about a big (nominal) crash in the first few years of retirement is the wrong way to think about sequence of returns risk. Inflation is the bigger risk by a fair amount. Of course, the best thing is to look at both together: real equity returns.
So... why do you 'have doubts that using "real returns" like this is as meaningful it appears' ?
The post and Kitces are talking about two slightly different uses of real returns. My post is just looking at the link between real returns and SWR. Unsurprisingly, it is high but perhaps not as high as one might guess. After all...besides cumulative real returns...what else contributes to SWR?!? (For one, just using cumulative real returns like that leaves out sequence of returns risk.) In essence, my post is purely about looking backwards in time.

Kitces post is more about looking forward. He uses current CAPE10 and compares that to future real returns. I think it would be interesting to look instead at future nominal returns based on CAPE10. My current working hypothesis is that CAPE10 helps us understand (something like) 50% of future nominal returns. But it doesn't tell us anything about future inflation. If we engage in some bad, hand-wavy, Internet Math™ ...

...nominal returns explain 25% of SWR...
...CAPE10 explains 50% of nominal returns...

So CAPE10 (and valuations in general) explain 12% of SWR.

If you're willing to grant me that dodgy math, then I'm not saying one should ignore valuations. After all, it may be easy to incorporate them in one's retirement plan. But something with only 12% explanatory power seems more like a small tilt and less like something you should read 100 headlines a week about :D

(The above math is likely wrong but I think of it more as motivation for doing a multivariable decomposition instead of relying comparing things to "bundled" numbers like real returns.)

As a further undeveloped thought exercise, if I've convinced myself that inflation is a bigger risk to retirement than the other factors that are more commonly discussed...then what are the implications for portfolio design? Does that mean that nominal bonds are even more questionable? (If inflation is a bigger risk than sequence of returns then things like "bond tents" and increasing equity glidepaths might be precisely the wrong answer.) Does it mean that international diversification is more important? (Outside of the 1970s, how correlated in inflation globally?) Does it mean that Larry Swedroe's liquid alts are more important? Does it mean that more emphasis should be placed on non-Boglehead investments like property? I haven't really got any great answers to those questions but that's the kind of thing I wonder about as I've become less worried about sequence of (nominal) returns and more worried about sequence of inflation.

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Re: philosophicaleconomics predicts 4% real equity returns

Post by siamond » Wed Feb 28, 2018 4:35 pm

AlohaJoe wrote:
Mon Feb 26, 2018 9:41 pm
...nominal returns explain 25% of SWR...
...CAPE10 explains 50% of nominal returns...

So CAPE10 (and valuations in general) explain 12% of SWR.
Yes, sorry, that is shoddy math! Correlation numbers (R2) aren't additive, and can't be subtracted from one another. Actually, it turns out that CAPE10 is highly correlated with SWR (R2 was around 0.7 for a 60/40 portfolio). See below!
siamond wrote:
Sat Feb 17, 2018 2:30 pm
willthrill81 wrote:
Sat Feb 17, 2018 2:10 pm
Kitces found back in 2008 that there was a strong relationship between CAPE and the SWR for a 60/40 portfolio for the following 30 years. I'd call that practical, actionable, and useful.
This is a really good point. Most writers focus on the relationship between expected returns models (CAPE-based or else) and future actual returns. Few writers look at the (much more useful, indeed) relationship between expected returns and withdrawal methods, and yes, the SWR metric, when used on individual cycles, is -somewhat counter-intuitively- a good proxy for that, and easy to compute. When I modeled those things, I went straight to actual variable methods, but this is harder for people to quickly grasp. I'm going to redo (and extend) Kitces CAPE/SWR math, and publish the results.
I did follow on this idea, and just published an article on the Bogleheads blog that details the results, please check here:
CAPE and Safe Withdrawal Rates
Last edited by siamond on Wed Feb 28, 2018 4:58 pm, edited 1 time in total.

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Re: philosophicaleconomics predicts 4% real equity returns

Post by willthrill81 » Wed Feb 28, 2018 4:50 pm

siamond wrote:
Wed Feb 28, 2018 4:35 pm
AlohaJoe wrote:
Mon Feb 26, 2018 9:41 pm
...nominal returns explain 25% of SWR...
...CAPE10 explains 50% of nominal returns...

So CAPE10 (and valuations in general) explain 12% of SWR.
Yes, sorry, that is shoddy math! Correlation numbers (R2) aren't additive, and can't be subtracted from one another. Actually, it turns out that CAPE10 is highly correlated with SWR (R2 was around 0.7 for a 60/40 portfolio). See below!
siamond wrote:
Sat Feb 17, 2018 2:30 pm
willthrill81 wrote:
Sat Feb 17, 2018 2:10 pm
siamond wrote:
Sat Feb 17, 2018 1:59 pm
So you quoted extremely blunt math (instead of the one I suggested) on already blunt numbers, and yeah, you find something very blurry. No surprise. It does remain blurry when using better math, mind you. Oh well, we can re-discuss the whole topic when you get closer to retirement. Then you may start to better appreciate the value of mid-term financial planning and more subtle withdrawal methods.
Kitces found back in 2008 that there was a strong relationship between CAPE and the SWR for a 60/40 portfolio for the following 30 years. I'd call that practical, actionable, and useful.
This is a really good point. Most writers focus on the relationship between expected returns models (CAPE-based or else) and future actual returns. Few writers look at the (much more useful, indeed) relationship between expected returns and withdrawal methods, and yes, the SWR metric, when used on individual cycles, is -somewhat counter-intuitively- a good proxy for that, and easy to compute. When I modeled those things, I went straight to actual variable methods, but this is harder for people to quickly grasp. I'm going to redo (and extend) Kitces CAPE/SWR math, and publish the results.
I did follow on this idea, and just published an article on the Bogleheads blog that details the results, please check here:
CAPE and Safe Withdrawal Rates
Great work on that paper Siamond! It indicates that we may well be in a situation where the '4% rule' is needed and may be nearly exhausted over a 30 year retirement. But since there are naturally safeguards* to this approach anyway, I think that retirees who use it, given that they understand the caveats, will be fine.

*These safeguards are that (1) virtually no retirees will blindly maintain their spending when their portfolio has significantly declined and (2) most 65 year olds (traditional retirement age) will not survive to age 95.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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Re: philosophicaleconomics predicts 4% real equity returns

Post by lazyday » Wed Feb 28, 2018 9:40 pm

siamond wrote:
Wed Feb 28, 2018 4:35 pm
CAPE and Safe Withdrawal Rates
Note: It would seem tempting to use the bond’s current SEC yield instead of the 2% constant, as it is a fairly good expected returns model for nominal IT bonds returns in the following decade. Unfortunately, adjusting it for expected inflation and using such numbers for a longer horizon (e.g. 30 years) proved problematic, as the author experienced when trying. The historical ups and downs of bond’s real returns in the US (and other countries) did follow a rather unpredictable trajectory.
In the set of charts below this (using 1/CAPE and 2%) it might be interesting to see 100% equity. A 100% equity portfolio isn’t practical for many retirees, but it would remove the problem of simply using 2% even though expected bond returns vary. The chart might also be useful for someone who uses TIPS to build an LMP (no rebalancing) and wants to know what WR might be realistic for the RP (Risk Portfolio of equities) for spending on luxuries.

Or instead of considering the LMP and RP separate, we might conservatively use equities to Match Liabilities. If we consider ½ of the dividend yield to be safe as W Bernstein has mentioned, then we might use a portfolio where minimum spending needs are met by a TIPS ladder supplemented by ½ of the starting dividend yield * starting equity value. Or maybe that’s too conservative. We might instead use a TIPS ladder supplemented by 1/CAPE * starting equity value, though I imagine this is too aggressive.

(I say “starting” to focus on decisions before retirement. Of course this can be recalculated after retirement, though if spending is increased we should be conservative to avoid finding the year where the formula fails.)

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Re: philosophicaleconomics predicts 4% real equity returns

Post by MotoTrojan » Wed Feb 28, 2018 10:20 pm

Bwlonge wrote:
Wed Feb 14, 2018 5:47 pm
Does return even really matter that much?

Saving $500/mo at 7% for 40 years= $1,327439
Saving $500/mo at 4% for 40 years= $593,911

Saving $1000/mo at 4% for 40 years= $1,187,822

:(
I would suggest you go with:
Saving $1M/mo at 4% for 40 years= $1,187,822,000

Not sure what you are trying to say. Doubling your contribution amount is not a freebie, and if it was then would you not prefer saving $1000/mo at 7%?

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Re: philosophicaleconomics predicts 4% real equity returns

Post by siamond » Wed Feb 28, 2018 11:23 pm

siamond wrote:
Wed Feb 28, 2018 4:35 pm
CAPE and Safe Withdrawal Rates
lazyday wrote:
Wed Feb 28, 2018 9:40 pm
In the set of charts below this (using 1/CAPE and 2%) it might be interesting to see 100% equity. A 100% equity portfolio isn’t practical for many retirees, but it would remove the problem of simply using 2% even though expected bond returns vary. The chart might also be useful for someone who uses TIPS to build an LMP (no rebalancing) and wants to know what WR might be realistic for the RP (Risk Portfolio of equities) for spending on luxuries.
What we're trying to do here is to find a quantity that has a really solid chance of being a lower cap for the SWR to come, while not being overly conservative (i.e. the worst possible case). I don't see that using the historical average (inflation-adjusted) for bonds is that troublesome in such equation, when combined with the stock portion of the equation. If it's overestimated, then stocks returns will compensate, money has to go somewhere (probably what we're seeing right now, actually). And I really can't think of any other way, to be honest.

Still, I followed on your idea (thanks for the feedback!), and took a quick stab at assembling the red dots/blue dots graph for 100% stocks, and the approach breaks down, many blue dots (1/CAPE) end up being over the red dots (SWR). This isn't entirely surprising, as the sequence of returns risk is then maximized, and this can really make SWR go all over the place. Out of curiosity, I also took a quick stab at assembling the red dots/blue dots graph for a 20/80 AA, and then the blue dots get way too much conservative. Extremes just don't work well here.

Overall, it appears that the sweet spot with this approach is roughly limited to Ben Graham's guidelines, no more than 75% equities, no less than 25%... And I would really insist on the fact that this is a coarse tool that should not be used blindly, re-assess at times, follow common sense.

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Re: philosophicaleconomics predicts 4% real equity returns

Post by lazyday » Wed Feb 28, 2018 11:59 pm

drawing conclusions from 90 years of data (1927-2017), hence only 3 non-overlapping periods of 30 years, would not satisfy any statistician
I suppose this is particularly true for the quintile approach. The most expensive quintile includes few if any data points where both CAPE was as high as today while bond yields were as low as today.

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Re: philosophicaleconomics predicts 4% real equity returns

Post by siamond » Thu Mar 01, 2018 10:13 am

lazyday wrote:
Wed Feb 28, 2018 11:59 pm
drawing conclusions from 90 years of data (1927-2017), hence only 3 non-overlapping periods of 30 years, would not satisfy any statistician
I suppose this is particularly true for the quintile approach. The most expensive quintile includes few if any data points where both CAPE was as high as today while bond yields were as low as today.
Yes, I am not a big fan of the quintile table. I included it to be consistent with Michael Kitces' own research, but somewhat reluctantly. For the reason you mentioned, but also because percentiles (incl. quintiles) are essentially forms of historical averaging. And personally, I'd rather stay clear of assuming that there is some sort of ideal CAPE value being a 'constant of the universe'. This is another reason for which I like the 1/CAPE metric much better, it doesn't make any assumption about a historical mean to return to.

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