Retirement Planning: The Dangers of Thinking the Past Will Look Like the Future

Retirement planning brings together almost every aspect of financial planning: Cash Flow, Tax Planning, Goals, Insurance and Estate Planning. But at the heart of retirement planning is your portfolio and what you hope to earn from your investments.

At some point, you will rely on your portfolio to provide part of your income so estimating what your portfolio will earn is crucial. Estimate too high, and you could go broke. Estimate too low, and you force yourself to work longer than is necessary.

Unfortunately, most people (and even most financial advisors) use historic asset returns as their estimate. At first glance, this makes sense. We have nearly a century of data on some asset classes and almost 50 years for most others. Why not use the historic average? Wouldn’t that be the best guess?

As it turns out, no. Indeed, this may be the biggest mistake you can make.

Why? Because asset classes produce wildly different returns than their historic average, even over long periods of time.

For example, here are the after inflation returns, i.e. real returns, of the S&P 500, Five-Year Treasuries and a portfolio composed of equal amounts of both from 1926 to November 2018:

Annual Real Return – 1926 to Nov 2018

S&P 500 Index

7.22%

Five-Year Treasury Bonds

2.15%

S&P 500/Five-Year Treasury Bonds

5.21%

Based on data from Returns 2.0

So, if you had a portfolio of 50% S&P 500 and 50% Five-Year Treasury bonds, you would assume that you’d earn more than 5% a year above inflation and plan your retirement accordingly.

But what happens if you retired in 1966? Well, over the next 15 years, those assets and your portfolio of 50% S&P 500 and 50% Five-Year Treasury Bonds would have “earned” this:

Annual Real Return – 1966 to 1980

S&P 500 Index

-0.12%

Five-Year Treasury Bonds

-1.36%

S&P 500/Five-Year Treasury Bonds

-0.38%

Based on data from Returns 2.0

If you’d used historic averages to plan your retirement, you’d likely be well on your way to going broke.

So, what can we do? Is there a way to know whether we can expect high or low returns from our portfolio? Surprisingly, to a degree, yes.

Nobody can predict the future precisely, but when it comes to long-term (7 to 20 years) expected returns on assets, there are tools that gives us a range of what to expect. We’re not talking about a GPS telling us the exact address; more like a compass pointing us in the general correct direction.

Valuations, i.e. what you’re paying for an asset, and interest rates do a pretty good job of telling us what range of returns that we can expect over the next decade or so from stocks and bonds. For example, look at this chart from O’Shaughnessy Asset Management showing how much of future stocks returns are explained (R^2) by various valuation metrics – Price to Retained Earnings (PRE), Cyclically Adjusted Price to Earnings (CAPE) and Trailing 12-Month Price to Earnings (ttm P/E).

Valuations and Future Returns

As you can see PRE can explain around 75% of future earnings from around 15 years out to around 22 years. In my world, that’s about as close as we’ll ever get to predicting the future.

Now, look at this table compiled by Ben Carlson based work by Meb Faber of Cambria Investments showing stocks returns based on different starting CAPE ratios. (The CAPE is simply a long-term Price to Earnings ratio. Instead of looking at one year, it looks at the S&P 500’s earnings over the past decade adjusted for inflation to smooth out earnings ups and downs.)

CAPE and Annual Returns

As you can see, on average, you earn more over the next decade when stocks are cheap than when they’re expensive. It’s not guaranteed. There are times when the stock market is expensive where investors get lucky for the next decade and earn very good returns. And there are times when the stock market is cheap and investors earn fairly low returns. But look at the “Low” scenarios, and you’ll notice the dangers of an expensive market.

When the stock market is cheap, even your worst-case scenario is manageable. But when stock markets are expensive, you face the chance of horrendous returns.

When planning for retirement, assuming that you’ll earn historic returns is dangerous. Valuations gives a decent guide for what range of returns to expect over the next decade or two. You should look at what those valuations are telling you and plan accordingly.

 

 

About Mark Helm, CFP, EA

Mark Helm is a Certified Financial Planner and Enrolled Agent. He is the founder of Helm Financial Advisors, LLC, a fee-only financial planning firm dedicated to helping people reach their life goals.
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