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Trending: Top 3 U.S. Conservative Allocation Funds
Justin Kuepper
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These funds tend to allocate assets in a conservative manner with above average...
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To begin with, today’s bond yields are now way below the historical return of 5.3 percent. Thus, an investor should in no way assume a return of 5.3 percent going forward. As I write this, the current yield on the five-year Treasury is just 1.3 percent.
When it comes to forecasting equity returns, the best tool we have is the adjusted Shiller CAPE 10 ratio. This ratio is currently at about 26.5, providing an earnings yield of about 3.8 percent. We need to adjust that figure to consider the fact that the Shiller CAPE 10 is lagging earnings by an average of five years. If we then assume an approximately 2 percent growth in real earnings, we can multiply 3.8 percent by 1.1 [1 + (0.02X5)] to get an earnings yield of about 4.2 percent. That gives us the expected real return on stocks.
We also need to add in expected inflation to get the nominal expected return. The current consensus forecast from the Philadelphia Federal Reserve’s most recent survey of professional economists is for inflation of 2.2 percent over the next 10 years. That leaves us with a nominal return estimate of 6.4 percent for stocks.
Clearly, today’s 60/40 portfolio cannot be expected to earn anywhere near the historical return of 8.7 percent. The weighted average of the current five-year Treasury yield (1.3 percent) and the adjusted CAPE 10 earnings yield (6.4 percent) leaves us with an expected return of 4.3 percent in nominal terms and just 2.1 percent in real terms. And both are well below the historical average. Even if you assume that the current regime of zero-to-negative real bond yields won’t last much longer, expected returns are now much lower than the historical levels.
While we cannot know the future, investors might get lucky and earn a higher return than the evidence indicates they should expect. But building an investment plan based on luck isn’t an intelligent strategy. Investors with financial plans that depend on earning the historical rate of return, instead of today’s best estimate of future returns, are likely to not have sufficient assets to sustain their planned spending. And living without sufficient assets to support the planned-for lifestyle isn’t an outcome most people would even care to contemplate. Even worse is running out of money. That’s virtually unthinkable for most people.
It’s also important to note that what holds for individuals also often holds for state and local, as well as corporate, pension plans. Many have adopted return assumptions that are either optimistic or, even worse, wildly optimistic. The result will likely be that future taxpayers will have to foot the bill for underfunding, pensioners will not get the benefits they are counting on, or some combination of both.
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News
Justin Kuepper
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These funds tend to allocate assets in a conservative manner with above average...
We will take a closer look at the recent surge in treasury yields...
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We are looking at the industry themes of client emotional appeal, the power...
Find out why $30 trillon is invested in mutual funds.
Download our free report
Find out why $30 trillon is invested in mutual funds.
Download our free report
Find out why $30 trillon is invested in mutual funds.
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To begin with, today’s bond yields are now way below the historical return of 5.3 percent. Thus, an investor should in no way assume a return of 5.3 percent going forward. As I write this, the current yield on the five-year Treasury is just 1.3 percent.
When it comes to forecasting equity returns, the best tool we have is the adjusted Shiller CAPE 10 ratio. This ratio is currently at about 26.5, providing an earnings yield of about 3.8 percent. We need to adjust that figure to consider the fact that the Shiller CAPE 10 is lagging earnings by an average of five years. If we then assume an approximately 2 percent growth in real earnings, we can multiply 3.8 percent by 1.1 [1 + (0.02X5)] to get an earnings yield of about 4.2 percent. That gives us the expected real return on stocks.
We also need to add in expected inflation to get the nominal expected return. The current consensus forecast from the Philadelphia Federal Reserve’s most recent survey of professional economists is for inflation of 2.2 percent over the next 10 years. That leaves us with a nominal return estimate of 6.4 percent for stocks.
Clearly, today’s 60/40 portfolio cannot be expected to earn anywhere near the historical return of 8.7 percent. The weighted average of the current five-year Treasury yield (1.3 percent) and the adjusted CAPE 10 earnings yield (6.4 percent) leaves us with an expected return of 4.3 percent in nominal terms and just 2.1 percent in real terms. And both are well below the historical average. Even if you assume that the current regime of zero-to-negative real bond yields won’t last much longer, expected returns are now much lower than the historical levels.
While we cannot know the future, investors might get lucky and earn a higher return than the evidence indicates they should expect. But building an investment plan based on luck isn’t an intelligent strategy. Investors with financial plans that depend on earning the historical rate of return, instead of today’s best estimate of future returns, are likely to not have sufficient assets to sustain their planned spending. And living without sufficient assets to support the planned-for lifestyle isn’t an outcome most people would even care to contemplate. Even worse is running out of money. That’s virtually unthinkable for most people.
It’s also important to note that what holds for individuals also often holds for state and local, as well as corporate, pension plans. Many have adopted return assumptions that are either optimistic or, even worse, wildly optimistic. The result will likely be that future taxpayers will have to foot the bill for underfunding, pensioners will not get the benefits they are counting on, or some combination of both.
If you’ve enjoyed this article, sign up for the free MutualFunds.com newsletter; we’ll send you similar content weekly.
Receive email updates about best performers, news, CE accredited webcasts and more.
News
Justin Kuepper
|
These funds tend to allocate assets in a conservative manner with above average...
We will take a closer look at the recent surge in treasury yields...
Kristan Wojnar, RCC™
|
We are looking at the industry themes of client emotional appeal, the power...
Find out why $30 trillon is invested in mutual funds.
Download our free report
Find out why $30 trillon is invested in mutual funds.
Download our free report
Find out why $30 trillon is invested in mutual funds.
Mutual Fund Education
Justin Kuepper
|
Let's take a closer look at how ESG investments have outperformed during the...
Mutual Fund Education
Daniel Cross
|
While CITs and mutual funds share many similarities, there are some key differences...
Mutual Fund Education
Sam Bourgi
|
The phrase ‘bear market’ has been thrown around a lot lately, but it...