Trend Following: Not a Unicorn, But a (Potentially) Useful Horse

In my last article, I introduced the investment strategy of trend following – and my reluctance to believe in it. In the end, the evidence was too overwhelming for me to ignore. A trend following screen on stocks did appear to reduce an investor’s risk (especially of big market drops) while achieving similar returns as a buy-and-hold strategy.

But I couldn’t shake my suspicion that something wasn’t quite right. One of my core beliefs (perhaps “the” core belief) is that investing strategies that enhance your returns (or give you equal returns at lower risk) over simply owning an index fund should cause pain. If they don’t cause investors pain and investment advisors to get fired, everyone would use them, and they would disappear.

Where was the pain in trend following? How could following this strategy get me fired?

Then it hit me. I was looking at the numbers of using trend following, but I wasn’t looking at the human experience for investors over the long run. From that angle, I realized that trend following is a pain train; it’s almost designed to get me fired. (I was beginning to warm up to trend following.)

First, a trend screen on stocks doesn’t work most of the time. (Hmm, maybe you can’t time the market.) Yeah, getting out of stocks when they started to trend down was great in 2008 and 2009, but what about in 2011 when the S&P 500 fell 16% over several months – triggering our trend screen and moving the portfolio to cash – only to shoot right back up to new highs while we sat in cash waiting for the trend screen to signal the “all clear” to move back into stocks.

You can see in the chart below how the trend screen would have caused us to sell just as the market bottomed out and to buy back into the market after missing a large run up in price. We ate all of the downturn but missed a good part of the rebound.

 

Trend example that did not work

For Illustration Purposes Only

Similar market moves – known as “whipsaws” – happened again in 2010 and 2016.

By its nature, trend following is a defensive strategy. As soon as trouble starts to appear, it moves you to cash and waits until the coast is clear before going back in. It’s geared to avoid the big crash. But that protection comes at a price: You will miss out on gains during bull markets when stock downturns are temporary hiccups on the way to new highs.

In essence, a trend screen is like an insurance policy: It pays off big during a disaster, but during good times, you’re out the cost of the premiums. Over time, they even out.

We can see this by breaking down the annualized returns of two portfolios over the last decade. The first portfolio used a 10-month moving average trend screen to decide when to be in the S&P 500 index and when to be in cash. The second portfolio simply bought and held the S&P 500 index.

 

 

2008-2017

2008-2009

2010-2017

Trend Following

9.38%

11.61%

8.83%

Buy-and-Hold

8.37%

-10.75%

13.76%

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.

 

The returns are exactly what you’d expect to see. The trend following portfolio did a great job during the bear market of 2008 to 2009 but has solidly trailed a buy-and-hold strategy during the bull market. Taken together, the overall annualized returns were fairly similar.

While I’m sure that investors would have been glad to have the trend following portfolio during the dark days of the Great Recession, I’m not sure how many investors would be willing to put up with the subsequent eight years of underperformance.

Trend following seems to have the same downside as other factor premiums (small, value and momentum): Long periods of underperformance that the vast majority of investors are not willing to accept.

It also has an added psychological hurdle: It looks like market timing. And perhaps it is, though it’s a strange type of market timing in the sense that it openly acknowledges that it doesn’t work most of the time.

Those caveats aside, trend following has a number of inviting attributes. First, it does seem to generate similar long-term returns as buy-and-hold but at less risk. Second, it complements buy-and-hold extremely well. Just as stocks and bonds pair nicely because they often do well when the other is doing poorly, trend following typically does well right at the time that buy-and-old is doing poorly (bear markets) while buy-and-hold portfolios typically do well when trend following portfolios struggle (bull markets).

Despite my early hesitations, I’ve come to believe that allocating a portion of an investor’s portfolio to a trend following strategy can be a useful addition.

However, I also believe that this strategy is not for many (maybe even most) people. For some (and do I understand this group), the feeling that they’re timing the market will never let them feel comfortable with trend following. For others, the fact that it doesn’t work most of the time will frustrate them into quitting the strategy. And, of course, for many investors, the long periods of underperformance relative to a benchmark will cause them to abandon the strategy before it can work.

As always, the best investment plan isn’t the plan that earns you the highest rate of return; it’s the investment plan that lets you sleep at night and that you can stick with during the inevitable periods of poor performance.

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Trend Following: My Capitulation to the Evidence

I’ve always prided myself on being an evidence-based investment advisor. Don’t try to persuade me with a good story. I want a reasonable hypothesis, backed by data and rigorous statistical analysis. I want transparent, peer-reviewed research that’s gone through the ringer of other academics and investment practitioners, who, in turn, bring their own data and statistical analysis to either support or counter your research. I then want proof that what works on paper works in the real world.

I’ve also always said that I would follow the evidence where it leads and not let my own prejudices (my own stories, if you will) cloud my judgement.

Little did I know that my commitment to following the evidence would force me to question my most cherished belief: You can’t time the market.

For nearly 20 years, I’ve preached with an almost zealot-like fervor to anyone who would listen that market timing is a fool’s game. You can’t do it so don’t try. I was comfortable in that belief because the data backed me up. Year after year, the data showed that buy-and-hold investors using index funds outperformed active investors. Sure, a few lucky investors and maybe even a few skilled ones could time the market, but since we couldn’t identify the lucky from the skilled, it was pointless to try. There was never a set of rules – a system – that could be tested and evaluated, so case closed.

But several years ago, research started popping up looking at a strategy known as trend following. Now, trend following wasn’t new, but solid research examining the strategy was. The research – which backed the use of trend following – did not sit well with me. Why? Well, let me explain what is trend following, and you’ll understand.

Trend Following

Trend following is exactly that, you follow the trend. While there are thousands of ways to implement this strategy, it boils down to betting on assets that have been trending up in price and getting out of assets that are trending down in price. (You can also bet against down-trending assets if you want to try and profit off of their decline.)

The chart below shows a trend line for the S&P 500 index performance from mid-2006 to 2010. The first red box shows where the S&P’s trend begins moving down while the second bubble shows when the S&P begins trending back up.

 

Trend example

For Illustration Purposes Only

 

In this case, I used a 10-month moving average for the trend line. A trend following strategy for the S&P 500 is simple: Be in the S&P 500 when the index’s current price is above its 10-month moving average and go to cash when the S&P’s price falls below its 10-month moving average.

Now, you can see why trend following would cause a diehard buy-and-hold investor such as myself all kinds of heartache. First, it’s laughably simple. Nothing this simple could work, right. Second, it looks a lot like market timing. And we all know that market timing doesn’t work.

The problem was that the research from multiple well-known academics and investment practitioners was showing that this strategy, in fact, has been remarkably effective at achieving similar returns as buy-and-hold but at much less risk. Annoyed, but intrigued, I did some of my own research.

What did I find? The same results.

Using PortfolioVisualizer, I compared the performance of the S&P 500 index using a 10-month moving average trend screen against a buy-and-hold strategy from 1971 to 2017.

Annualized Return (CAGR) Standard Deviation Maximum Drawdown
Trend Following 10.88% 11.39% -23.54%
Buy & Hold Portfolio 10.68% 14.96% -50.95%

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.

The returns are nearly identical, but the risk for the trend following portfolio is dramatically reduced. The annual ups and downs (standard deviation) were less with the trend following portfolio, but much more importantly, the gut-wrenching drawdowns were cut in half.

I ran the same test on international stocks, small stocks, value stocks, etc. The results were similar. A trend screen gave you similar returns but at much less risk.

As much as I didn’t like the whole concept of trend following, I was finding it very hard to reject the evidence. On the other hand, I couldn’t shake the feeling that when something sounds too good to be true, it’s not.

In my next post, I’ll reveal my “ah-ha” moment when I finally understood why trend following might be a viable strategy. I also finally understood why it may not be the right strategy for many, if not most investors.  (Hint: I figured out its dark side.)

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Peering Into The Future: Sort Of

I often tell my clients that the different stock market valuation methods can help us estimate future stock market returns. Naturally, this gets them pretty excited. I mean, knowing the future is pretty helpful when it comes to investing, right?

Well, not so fast.

Stock market valuations are more like a hazy compass than a GPS system. Valuations can usually point you in the general right direction, but they can’t tell you what road to take or how long the journey will last. In essence, valuations are very useful for long-term planning, not so much for specific short-term moves.

As I explain, when stocks are expensive relative to history, it generally means lower long-term returns – but, importantly, not always. Sometimes expensive stocks just stay expensive or even get more expensive. And sometimes cheap stocks get even cheaper, at least for a little while.

Basically, you have a range of returns at each level of valuation, but the subsequent returns definitely show that on average cheap stocks earn higher returns over time compared to expensive stocks. You just can’t rely on it for short-term (less than ten years) planning.

Frankly, it’s a difficult concept to understand in the abstract. Thankfully, a smart German researcher, Norbert Keimling of StarCapital, has created the perfect graph to illustrate what I mean.

 

starcapital-cape-page-001

 

The chart shows the future 10-15 year annual real returns (i.e. above inflation) of stocks markets in the United States and other developed countries from 1881 to 2015 at various starting valuations. In this case, Keimling is using the CAPE to value stocks.

So what’s the CAPE? The “cyclically adjusted price/earnings” (CAPE) ratio, is a valuation method designed by nobel-prize winning Prof. Robert Shiller. Shiller takes the current market price of a stock market such as the S&P 500-stock index for the United States, divides by the total earnings of the companies in the index averaged over the past 10 years, adjusting all the numbers to account for inflation.

By using an average of 10 years of earnings, the CAPE takes into account the ups and downs of the business cycle. After all, we don’t want to value a company (or stock market) based on one or two unusually good or bad years.

The chart shows the current CAPE ratio for various countries. For instance, the United States is at a CAPE of ~27, while the Russian stock market is on the other end of the spectrum at around a CAPE of 6.

The chart clearly shows three important things:

  1. Stock markets with lower CAPEs tend to earn higher returns over the next decade.
  2. The range of returns is high enough that you can’t rely on the CAPE for market timing.
  3. The United States stock market is not poised for high returns; indeed, we’d be happy with average returns.

So should we put all of our money in Russian stocks? Should we ditch U.S. stocks? The answer to both questions is, No. U.S. stocks have had a very high CAPE relative to other countries for the past five years. What happened over those five years? U.S. stock returns crushed international stocks.

The CAPE isn’t for market timing!

However, you’d be crazy to assume that U.S. stocks will earn their historic real return over the next decade given the U.S. market’s current CAPE valuation. Generally, that CAPE valuation led to annual real returns between 2.0% and 6.0%, so let’s just use 4.0% for our best guess. That compares to ~6.5% historically for U.S. stocks. (But, remember, that CAPE level also has seen 10-15 year annual real returns as low as -2% and as high as 11%.)

Our hazy compass is pointing to low returns for U.S. stocks over the next decade with non-U.S. developed international stocks producing reasonable returns relative to history (~6.0% annual real return) and emerging markets earning closer to 7.0% annual real returns.

Given that bonds aren’t expected to earn much, if anything, over inflation for the next decade, Americans investors that hold only U.S. stocks and bonds should expect very low returns relative to history. For example, an investor that has a portfolio of 60% U.S. stocks and 40% bonds could expect an annual real return of ~2.5% a year. If we add in 2.5% inflation, the investor would earn ~5.0% nominal.

Historically, Americans have earned ~4.5% to 5.0% a year above inflation and 7.5% to 8.0% nominal for that same portfolio. If Americans continue to use those historical numbers in their retirement plan, they are likely in for a nasty surprise.

Americans need to plan for lower returns. They may be able to help mitigate those lower returns by diversify their stock allocation into developed international and emerging market stocks. But even if international stocks help their portfolios, Americans are still looking at lower returns relative to history.

Now is the time to adjust your plans.

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Hillary or Trump: Stop Worrying About Things Your Can’t Control

“There is only one way to happiness and that is to cease worrying about things which are beyond the power of our will.” – Epictetus

Almost every appointment ends the same these days. “Do you think we should do something with our investments in case (Trump or Hillary) wins?”

Given that I don’t have a clue which candidate will win nor what their victory would do to the stock market, I always reply that we shouldn’t make any moves. However, the question reminds me of my old mentor, Bert Whitehead.

Bert argued that one of the key reasons for what he called Financial Dysfunction (and personal dysfunction for that matter) was that people tended to believe that exogenous factors (those factors that are externally generated, such as interest rates or the price of oil) are more important than endogenous factors (those factors that internally generated in their lives, such as how much they earn, how much debt they are carrying and their relationships with others).

He joked that this was simply a fancy way of saying you are in control of your financial destiny even though it doesn’t appear to be that way in the midst of all the distractions that swirl around us every day. Bert argued that once people understood that they were in control, that what they do will have much more of an influence on their future than all of the things going on outside of their control, they start to make rapid progress toward financial freedom.

Bert even put together a nice little quiz to show people how much control they have over their financial lives. Why don’t you take it now?

Financial Future Quiz

Which of the following do you think will most impact your financial future?

Column A                                                                                  Column B

Interest Rates                                       or                         Keep Your Taxes as Low Possible

Your Specific Mutual Funds               or                         Being Diversified and Sticking to the                                                                                           Plan

Inflation                                               or                         Being a Wise Shopper

Industry/Technological Changes         or                         Improving Your Skills/Networking

The Political Climate                           or                        The Stability of Your Relationships

Globalization                                       or                         Purchasing the Right Home

Investment Returns                              or                        How Much You Save for Retirement

As you can see, you have more control over your financial future than outside forces, so stop worrying about the election. Whatever the results, you will have the power to deal with them, just as you have the power to deal with every other exogenous factor.

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“Sustainable Alpha” or Why an Investment Advisor’s Job Isn’t What You Think It Is

“You keep using that word. I do not think it means what you think it means.” Inigo Montoya from the 1987 film The Princess Bride.

“Alpha” is the holy grail of investing. Alpha simply means outperforming the appropriate risk-adjusted benchmark. Basically, alpha shows whether an investment manager is adding value.

The object of every active investment manager is to achieve as much alpha as possible. The object of every investor is to find those managers that achieve alpha.

Here’s the problem: Alpha is exceeding rare in the investing world, and, what’s more, it doesn’t seem to last long when you find it.

Indeed, Larry Swedroe wrote a nice book called “The Incredible Shrinking Alpha!” that shows how investment managers’ ability to capture alpha via clever and unnoticed strategies has shrunk dramatically over time as academics have uncovered their methods, which, in turn, has allowed other investment managers or even index funds to replicate those strategies.

So, is alpha dead?

Well, yes and no. Alpha generated by being smarter than everyone else in the room for long periods of time – what I’ll call IQ Alpha – appears to be going the way of dial up internet. It’s simply too difficult in a world of super computers, huge data bases and armies of genius-level finance experts (whom I’ve heard look a bit like this) to outsmart Wall Street for long.

However, all hope is not lost. A different form of alpha is achievable, and not just achievable, but achievable by us mere mortals. But beware, while this form of alpha doesn’t require a perfect SAT score, it does require something rarer: Discipline. Wes Gray, a former finance professor at Drexel University and founder of the investment firm Alpha Architect, calls this other form of superior performance “Sustainable Alpha.”

Wes uses a great poker analogy to explain sustainable alpha. For poker players, picking the right table is crucial. You need to know who the fish (the suckers) at the table are and who the sharks are. What’s more, you need to figure out a way to beat the other sharks.

The Fish

We know from actual results that your average investor is a fish. Tricked by brains that evolved to stay alive in the wilderness not Wall Street, investors make a host of behavioral mistakes that lead to mispricing any number of assets. We’re simply not mentally built to make good investment decisions.

The Sharks

Hedge fund managers, mutual fund managers and institutional money managers are the sharks. They literally have rooms full of the smartest minds in the world analyzing huge amount of data looking for any little advantage.

Looking at these competitors, we quickly realize that we’re not going to beat them via superior brain power. (Heck, they can’t even beat each other because their big, throbbing brains are canceling each other out.) Luckily, they have an Achilles’ heel that we can exploit.

Those asset mispricings that investors create through their bad behavior, well, they come with a poison pill for our fellow sharks.  You see, those mispricings that sometimes unfairly drive asset prices too far down or too far up can take a very long time to get corrected. A shark that tries to take advantage of those investor mistakes may have to wait years – sometimes more than a decade – to get rewarded.

This presents a serious problem for hedge fund managers, active mutual fund managers and institutional money managers. While they may be willing to wait, their investors are not. Research and surveys show that most investors won’t tolerate “underperformance” for more than a couple of years – if that. Money managers know that they can profit from investor mistakes over the long run, but they also know that their clients operate in the short run.

Employing a strategy that captures the alpha created by investors’ behavioral mistakes will get them fired, and they know it. For them, the alpha dangles just out of reach on a cliff’s edge.

That’s what makes Wes Gray’s alpha sustainable. Big-time money managers face too much career risk to go after it. The other sharks at the table can’t take that pot of cash.

But what if an investment advisor was careful about picking clients and helping them understand what investing really means? What if an investment advisor figured out that his or her real job was less about being the smartest guy in the room and more about educating clients on investing fundamentals and, more importantly, investing history so they were mentally prepared to wait out the eventual periods of underperformance?

As Wes likes to say, “To capture sustainable alpha, you need sustainable clients.”

People often think that an investment advisor’s job is to make a lot of moves, reacting to or anticipating trends in the market. It’s not. A good investment advisor is, above all, an educator. An educated client stops being a fish. An educated client with enough of an understanding of our investment strategy to maintain the discipline needed to capture sustainable alpha becomes a shark.

Stop being a fish and start being a shark!

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Squaring the Low Expected Returns’ Circle: Part II

“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” – John Maynard Keynes

In my previous blog, I showed the dismal expected returns for U.S. Treasury bonds and large-cap American stocks over the next seven to ten years. Your typical American investor with a 60% stock/40% bond portfolio is staring down the barrel of potentially devastating returns – ~2.5% a year above inflation compared to ~5.0% a year real returns they’ve earned historically.

Naturally, this leads to the obvious question: What can we do about it?

Well, you could spend less, save more and delay retirement for a couple of years. This would solve the problem for most people. However, from an investment perspective, you can also take some steps that could help improve your returns.

Look Abroad

While U.S. stocks look pretty expensive relative to history, international developed stocks and emerging markets stocks appear reasonably priced. Here’s the breakdown of expected annual real returns for stocks over the next seven to ten years:

U.S. stocks                                 4.0%

International Developed            5.5%

Emerging Markets                     7.0%

As you can see, valuations point to much better returns for international stocks. Sadly, valuations aren’t saying that international stocks are poised for great returns. In fact, they look quite average from a historical perspective; it’s just that they look good compared to the paltry expected returns on U.S. stocks.

Factor Diversification

For those not familiar with “Factor Diversification,” please take a look at my articles here, here and here. Simply put, factors are characteristics that tend to add a premium (additional return) to the underlying stock. Two of the most studied are the Small and Value premiums. Stocks with these attributes have historically outperformed the S&P 500. How much?

January 1928 to June 2016 annual nominal returns*

S&P 500                                        9.7%

U.S. Large Value Stocks              11.1%

U.S. Small Stocks                        12.0%

As you can see, owning value stock would have increased your returns by 1.4% a year, while owning small stocks would have increased returns by 2.3% a year. Unfortunately, factor investing has become more popular with institutional investors, so let’s estimate that going forward the value and small premiums will be worth ~1.0% a year each.

Putting It All Together

Armed with this knowledge, let’s look at a portfolio that’s globally and factor diversified:

Allocation                                                                               Expected Return

15% S&P 500                                                                                   4.0%

15% U.S. Small Value                                                                      6.0%

10% Large International Developed Stocks                                     5.5%

10% International Developed Small Value Stocks                          7.5%

10% Emerging Markets Value Stocks                                              8.0%

40% U.S. Treasury Bonds                                                                0.0%

If you do the math, you’d find that this portfolio is estimated to earn 3.6% annual real return, possibly a touch more due to rebalancing. (Incorporating another factor known as Momentum also likely would improve returns.) Now, that’s still below the historic 5.0% annual real return, but it’s far better than the 2.4% annual real return that we started with.

Why Doesn’t Everybody Do It

Ok, it’s seems like a no-brainer. Add international developed stocks, emerging market stocks, value stocks and small stocks to the stock portion of your portfolio and you likely will help boost your returns while adding diversification, which is always a good thing.

This begs the next question: If this is so obvious, why doesn’t everybody do it?

In a word: Psychology.

To quote Warren Buffet, “Investing is simple but not easy.” Everybody loves the “idea” of being diversified but finds the reality of owning stocks that go up and, particularly, down at different times than the S&P 500 extraordinarily painful.

For example, the S&P 500 has demolished international developed and emerging market stocks for the past FIVE years. If that’s not bad enough, the value premium and small premiums have both been NEGATIVE over that same period. Let’s look at what a $1,000 invested in each asset would have grown to over the past five years**:

S&P 500                                                   $1,770

U.S. Large Value Stocks                          $1,691

U.S. Small Stocks                                    $1,605

International Developed Stocks               $1,009

Emerging Market Stocks                          $985

Look at those international numbers again. You would have endured political turmoil and wild gyrations in stock values for five years just to be more or less flat, while American stocks soared. Most people can’t handle it. The pain becomes too much, and they bail out on their international stocks. The same thing happens with owning small and value stocks when they have long periods of dramatic under performance compared to the S&P 500.

Having a well-diversified portfolio works in the long run (think 10 to 15 years), but our minds don’t operate that way. If you install a washing machine, and it doesn’t work, you don’t wait 15 years to see if it will come around. You get rid of it. The same goes for employees. If you have an employee who has been terrible at their job for the past five years, you fire the person. And rightfully so! They are never going to get better.

But that’s not how investing works. Successful investing is a form of psychological torture, and your only defense is understanding why diversification works and knowing the history of asset returns, which prepares you for the long stretches (sometimes lasting longer than a decade) of under performance that eventually hit all assets.

So, yes, all the evidence (both academic research and live mutual fund returns) shows that a globally, factor diversified portfolio is the best option. In addition, valuations strongly suggest that this type of portfolio could be particularly useful over the next decade.

However, history also shows that unless you have a very good understanding of why a globally, factor diversified portfolio works, the odds are extremely high that you will not stick to the plan, in which case, you would have been better off staying with American stocks and accepting the expected lower returns.

My best advice is to prepare for lower returns and to get the education needed to adopt a globally, factor diversified portfolio.

*Based on Prof. Ken French’s Princeton database, using Large Value Index and Small Cap Index.

**Funds and indexes used are S&P 500 index, DFA Large Value fund, DFA Micro Cap fund, MSCI EAFE Index and DFA Emerging Markets Portfolio

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Squaring the Low Expected Returns’ Circle: Part I

“Face reality as it is, not as it was or as your wish it to be,” Jack Welch.

Alright, Jack, let’s face some reality. Investment returns for your average American investor over the next 10 years or so are not looking good. In fact, they’re looking bad. Actually, they’re looking terrible.

How bad? The best guess for a 60% stock/40% bond portfolio is ~4.0% nominal and ~2.5% real (above inflation) a year. Historically, you’d be looking at ~8.0% nominal and 5.0% real.

Yep, returns over the next seven to ten years could be around half of their historic average. Investors need to understand why this is the case and what they can do about it.

Why Are Expected Returns So Low

Predicting short-term (less than two years) and intermediate-term (two to seven years) investment returns is nearly impossible. However, when you go out a bit further, you can get a pretty decent idea of the range of returns that you can expect. Valuations on various asset classes aren’t a GPS, but they can point you in the right direction.

So, what are valuations on U.S. stocks and bonds showing? Pain, a lot of pain.

Let’s start with bond rates. Why start with bonds? Well, because bonds are easy. They tell you what they’re going to pay you over time. Throw in your best guess of inflation and you know what your real return (what you’ll earn on an investment above inflation – the only number that really matters) will be.

Ok, so what are bonds paying (yielding) these days? Not much. A 10-Year Treasury bond is paying about 1.5% a year. When you consider that 10-Year Treasury bonds have historically paid between 5% and 6% a year, you can see that bonds are paying far below their long-term average.

Alright, so what’s the expected inflation rate for the next 10 years? Unfortunately, inflation is also expected to be around 1.5%, which means that 10-Year U.S. government bonds over the next decade will be paying you right around zero percent a year above inflation. (Historically, 10-year Treasuries paid ~2.0% a year above inflation.)

Well, that’s not so great is it? But, hey, what about stocks? Stocks are the engine of growth, right?

Unfortunately, American stocks look a bit expensive relative to history. There are dozens of ways to value stocks, but they’re all pointing to the same place: U.S. stocks are poised to pay around 4.0% a year real return for the next seven to ten years. (Here’s a nice article showing how various valuation methods get to similar expected returns for big American stocks.)

Alright, let’s look at our 60% stock/40% bond portfolio.

60% (stock allocation) X 4.0% = 2.4%

40% (bond allocation) X 0.0% = 0.0%

Add those together and you get 2.4% a year real return. Throw in 1.5% a year for inflation, and you get ~4.0% a year nominal return.

If you’re thinking that this looks pretty bad, you’re right. Looking over the past century or so, we’ve seen times when bond valuations didn’t look good (as they do today), and we’ve seen times when stock valuations didn’t look good (as they do today); however, we’ve never a situation where BOTH stock and bond valuations look terrible at the same time. We’re truly in uncharted waters.

So, what do we do?

First, don’t panic. These expected returns are just best guesses. We could get better than expected returns or worse than expected returns. However, they are useful for planning purposes. When you have high valuations – like we do now – it’s extremely prudent to plan on lower returns because the chances are much higher that this will be the case.

Second, there are actions that you can take to improve your chances of achieving higher returns by properly diversifying your portfolio, something that we’ll look at in the next article.

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