Tag Archives: balanced portfolio

It’s Not A Bad Time To Rebalance

Maybe you don’t like a lot of fuss as an investor, and you want to buy-and-hold a simple portfolio for the long term. That’s fine, but you do have to rebalance periodically. And people who favor simplicity may do that rebalancing on a pre-set schedule – quarterly, semi-annually, or annually.

But if you want to be a little more active regarding your rebalancing, now’s not a bad time to consider doing it. Here are some asset class returns for the year through January 30, 2019:

You can see that stocks have done well, with the S&P 500 Index surging by around 8%. Small cap stocks have done even better, with the Russell 2000 Index rising more than 11%. Emerging markets stocks have bounced back too from a poor showing in 2018 with a n 8.67% return for the first month of this year. And finally, with interest rates seemingly under control, REITs have topped the list with a gaudy 11.78% return.

If you started the year with a balanced portfolio of, say, $100,000, the $60,000 you had in stocks could now well be over $63,000. The $40,000 you had in bonds, by contrast, might not even be at $40,500 at this point. It’s not necessary to rebalance, but if you have a tax-advantaged account like a 401(k) or an IRA, and you can switch funds without paying fees or commissions, it’s not a bad idea. If your $100,000 is now close to $104,000 because of the $3000 you’ve made in stocks and a few hundred dollars in bonds, go ahead and move around $1,000 from stocks to bonds. That will get your stock exposure back to 60%.

That’s not a huge move, but the great investor, Benjamin Graham, who understood investor psychology before behavioral finance became an academic discipline, knew that investors get antsy to do something. And if fees, commissions, or taxes aren’t an issue, rebalancing is a good way to satisfy that itch to trade without doing yourself harm.

Besides satisfying the desire for activity, rebalancing can help you in other psychological ways. If you rebalance, and the market drops, you can feel happy that you took at least some money off the table – even if it was only a small amount. If, on the other hand, the market goes up, you can be satisfied that you didn’t alter your target (60/40) allocation; you just returned your portfolio to it after the January gains altered it, booking some profits in the process. You still have 60% of your money working in stocks.

There will always be woulda-coulda-shoulda thoughts when markets move. When stocks go up,  you wonder why you didn’t have more money exposed to them. And when they go down,  you wonder why you didn’t have less. But a balanced portfolio is one that most people can live with psychologically. It provides enough exposure when stock go up to minimize regret. And it provides enough bond exposure when stocks go down to minimize regret.

Investors should understand, however, that a balanced portfolio isn’t perfect. It may well return much less over the next decade than it has over the very long term. That’s because bond yields are so low that it will be virtually impossible for bonds to deliver more than 3.5%-4%, depending on your mix of Treasuries and corporates and your average maturity. Also, stocks are trading at high prices relative to past long-term earnings, which is usually a situation that produces lower-than-average future returns. That’s more incentive to rebalance in accounts that won’t hit you with transaction fees or a tax bill for doing so.

Last, if you think we may get some inflation, you can take that $1,000 away from stocks and put it in gold or leave it in cash. The economy isn’t robust on many indicators, but, according to DoubleLine fund manager Jeffrey Gundlach, inflation can come from all the quantitative easing the Fed has done and the large amount of U.S. debt outstanding. If a balanced portfolio is likely going to deliver subpar returns, and debt turns out to be a problem, holding some alternatives to stocks and bonds is reasonable.

What Your Advisor Believes (And Why You Should Question It)

Chances are your financial advisor believes in two related intellectual theories that you should question them about.

In a recent article, the excellent columnist Brett Arends wrote about the two theories governing most financial advisors – the efficient markets hypothesis (EMH) and the capital asset pricing model (CAPM). These sound like impossibly complicated things, but they’re not. The first theory says prices are right, or nearly right all the time, and that it’s, therefore, basically impossible to beat markets. The second theory says historical asset class returns will repeat and that the more risk you take (with risk meaning volatility), the more return you will make. So, for example, stocks are very volatile, but they’ll produce the best returns — something like 10% annualized (or 6.5%-7% after inflation) – over longer periods of time.

Theoretical Problems

But the theories aren’t always right. For example, if stock prices reflect all available information, why are they so volatile, as Arends asks? It may be because that information is always incomplete, and as more information emerges prices change accordingly — and correctly. But extreme volatility may also exist because people are irrational or emotional, and substitute stories or “narratives” for more rigorous analysis or even basic common sense. The rise of the tech bubble, for instance, wasn’t an example of new information being priced in as much as it was an instance of people’s imaginations getting the better of them, andcausing them to inflate the prices of stocks that had no underlying earnings or even revenues.

More problems: why have U.S. stocks (the S&P 500 including dividends) produced a less than 6% nominal return from 2000 through November 2018? Why did they deliver nothing but dividends from the mid-1960s through the early 1980s? And if stocks are such inflation-beaters, why did the S&P 500, including dividends, return only 65 annualized in the 1970s, far underperforming that decade’s inflation?

Future Returns

The facts of the matter are that prices aren’t efficient and asset class returns may not repeat for the, say, 25-year period your retirement plan is counting on them to do so. Bonds returns, for example are easy to forecast. They generally follow the yield-to-maturity. That means a portfolio of 8-year or so domestic investment grade bonds, such as one finds in a fund tracking the Bloomberg Barclay’s US Aggregate Index, now will almost certainly deliver around 3.3%.

And for the S&P 500 Index to return 10% over the next decade, it must trade at a higher P/E ratio than it does now in addition to delivering around a 2% annual dividend payment and 4%-5% earnings-per-share growth. That’s possible, but unlikely, because U.S. stocks are trading at around 30 times their past 10-years’ worth of earnings. They’ve only been that expensive in their runs in 1929 and 2000. Although nobody can be certain, it’s more likely that P/E ratios will decline over the next decade, not increase, cutting into the 6%-7% nominal return from dividends and earnings-per-share growth. Adherents of CAPM, don’t view the world this way, and think prices can keep rising so that it’s almost a long-term investor’s birthright to achieve 10% annualized returns.

If your broker or advisor can’t respond to these objections that their assumed future returns might be off – by a lot – there’s a good possibility that they’re too dogmatic, and have swallowed academic finance without digesting it or thinking about it.

What this means for your portfolio

The problems in these theories mean your portfolio may not be set up to satisfy your financial plan. As Arends mentions in another article, for the decade from 1938 to 1948 a balanced portfolio went backwards relative to inflation. It did the same disappointing thing from 1968 through 1983. With the Federal Reserve taking us into uncharted waters and returns prospects for major asset classes so low, investors should look at cash, real estate, foreign stocks, and commodities, including gold.

None of these by themselves is foolproof. Some of them have performed well in some instances when stocks and bonds have faltered, and others have performed well at other times when stocks and bonds have faltered. The most important thing is that an advisor sensitive to how warped the current market and situation are right now may be your best defense against tepid stock and bond returns. Making sure your advisor hasn’t fallen hook, line, and sinker for the Efficient Market Hypothesis and the Capital Asset Pricing Model may be the best way for you to navigate the next decade or so in the markets.

Do You Really Need Half Your Money In Stocks?

We’ve all been conditioned to think the balanced portfolio is a touchstone of investing. For many investors, it provides enough exposure to the stock market (60%) to produce a healthy return and enough exposure to the bond market (40%) to provide ballast and a little income to a portfolio. Along the way, advisors like to say that investors have counted on beating inflation by 4 or 5 percentage points. Supposedly.

But, as MarketWatch’s Brett Arends points out, a balanced portfolio hasn’t always performed as advertised, and the upcoming decade might be one of those times. That means investors should consider other allocations (depending on their individual circumstances, of course).

First, from 1938 to 1948, a balanced portfolio trailed inflation. Then, again, from 1968 through 1983, a balanced portfolio trailed inflation, eroding a third of its value in real terms, according to Arends. Basically, a balanced portfolio struggles against inflation. And while it’s obvious why inflation hurts bonds with their fixed dollar payments, it also tends to hurt stocks, despite their assumed ability to benefit from companies passing on higher costs to customers through price increases.

There aren’t easy ways for investors to combat inflation, if it should arise. Gold and commodities helped in the 1970s. Real estate can help too, as inflation can cause property price appreciation and push rents higher. Some foreign stock markets might help. Arends points out that Japanese and Singaporean stocks took off in the 1970s. Corporate bank loans and floating rate corporate debt might also help, though, Arends notes Ben Inker of Grantham, Mayo, van Otterloo (GMO) in Boston says credit protections aren’t what they once were. Finally, Inker notes that cash is a reasonable choice in times of inflation. And cash, as Arends says, doesn’t have to be in U.S. dollars. It can be in Swiss Francs, for example.

The 1970 also saw observers like Harry Browne advocate a different kind of portfolio mix – 25% each in cash, long-term bonds, stocks, and commodities. The cash and commodities would help in inflation, while the long-term bonds would help in times of deflation.

That leads me to the argument that, if you’re going to maintain a static portfolio allocation, something like 30% stock exposure, with the rest in short-term bonds and cash might be reasonable for someone about to retire soon. My reasons are that stocks are too volatile for a portfolio in distribution, and they’re likely too expensive to deliver good future returns in any case.

First, although I cherry-picked the start date so that two severe bear markets are baked into this hypothetical study, this portfolio in distribution phase shows that 30% stock exposure is better for a retiree in a bear market than a more aggressive portfolio. A balanced portfolio worked reasonably well, but only dropping down to 30% stocks allowed the portfolio to remain intact in a nominal sense (though not in an inflation-adjusted sense). Taking money from a portfolio during a volatile stock market is a tricky business. Too much stock exposure – even when using the famous “4% rule” (4% withdrawal the first year and 4% more than the first withdrawal annually thereafter) can destroy someone’s retirement.

Second, it’s not clear that stocks will outperform bonds over the next decade in any case. Even if you’re not in distribution phase, making volatility less of a concern, you may not add return to your portfolio by adding stock exposure. That’s because the Shiller PE (current price of stocks relative to past 10-year inflation-adjusted earnings) is over 30, meaning stocks have to remain more expensive than they have in history barring one other time for the next decade to deliver more than a 4% or 5% return.

And if you do add U.S. stocks to your portfolio, you’ll likely be adding the same old volatility stocks have delivered in the past. Modern academic finance like to use something called the Sharpe Ratio, which is a volatility-adjusted return or indicates how much return an investment achieved per unit of volatility. This view of the world has its problems, because risk might not be volatility, but it can be useful in helping you decide whether you want to add a certain asset to a portfolio or not. Getting, say, 4% or 5% annualized from stocks and assuming their historical volatility is a lot worse than getting the customary 10% from stocks and assuming their customary volatility. Adding U.S. stocks to a portfolio at current prices makes for what modern academic finance would call an inefficient portfolio.

Foreign stocks are cheaper than their U.S. counterparts, but they’re not screamingly cheap. If a balanced portfolio seems reasonable to you, it may not be under today’s circumstances. Consider trimming at least some of that stock exposure and adding a few other asset classes. Those new additions may not shoot the lights out, but, chances are, neither will U.S. stocks for the next decade. Above all, don’t think there’s some rule that says you need half your money in stocks. The idea of the balanced portfolio has become so popular that it feels like heresy to some people to deviate from it. But investing isn’t about faith; it’s about assessing the circumstances and likely returns in as rational a way as possible. Remember also to get some help from an adviser in constructing a portfolio and completing a financial plan. Many asset classes that weren’t available in the past to retail investors are available now. An experienced adviser can help you use them well and manage the risks they contain.

Volatility Is The Price Of Admission To Financial Markets

If it feels to you as if volatility has returned to the stock market, you’re right. But, although we’ve had a bad month in October so far with a nearly 10% loss in U.S. stocks, the calm we’ve had over the past few years is more unusual. And that makes this volatility feel worse than it should.

Garden Variety Correction

Here are a few statistical facts that should put the recent volatility into perspective. First, the S&P 500 Index was up around 11% for the year at its recent peak, including dividends. Now, through Wednesday, October 24th, it’s up 0.88% for the year. That means we’ve had a garden variety correction of around 10% so far. A bear market would be a decline of 20% from the market peak, and that would mean stocks would have to drop around another 10% from here to achieve that. It’s possible that will happen, but, even if it does, we’re only halfway there at this point.

And if we do enter a bear market, that won’t be so unusual either. We haven’t had one since the financial crisis and recession of 2008, after all, and this is now the longest running bull market in history. In fact, the length of the bull market, which started in March of 2009, is what makes any volatility feel unusual – even an ordinary 10% correction.

Calm Creates Complacency

Another important statistic that makes this correction feel unusual is that the S&P 500 Index didn’t drop in a single month in 2017 as it posted a nearly 22% return for the year. That was the first time in history the index didn’t record a negative month in a calendar year, and periods marked by such calm, especially if they come during  the longest bull market in history, make investors complacent.

There is a tendency for investors to feel invulnerable after such periods, even though that kind of calm should make investors nervous about when the next bout of volatility will arrive. The human mind doesn’t work that way though. Behavioral economics has shown that we have a strong tendency toward “recency bias,” meaning we extrapolate whatever hash happened in the recent past onto the future. That often makes us nervous when we should be calm and a little too calm when we should be a little nervous.

It’s true that at the beginning of this year volatility arrived again in February and March when the stock market gave up the roughly 10% gain it achieved during the first few weeks of January. But then calm ensued, and the market marched up nearly uninterrupted to match its earlier gain from January. By the beginning of October, complacency and recency bias had set in again.

Bonds Bring Ballast

Consider also that bonds have done their job by holding steady and bringing ballast to portfolios while stocks have dropped. The Bloomberg Barclay’s U.S. Aggregate Index is down 0.55% for the month of October. It’s true that you might expect bonds to be up a little for the month. It often happens that stock market declines cause a rally in investment grade corporate and especially government bonds, so a slight decline in the main bond index is a little unusual. But it’s nothing extreme, and having a part of your portfolio so stable when the stock market is declining can be a blessing.

This leads us to consider a balanced portfolio, which usually consists of 60% stocks and 40% bonds. This classic allocation has served generations of investors well with its moderate risk/reward profile, and it happens that a domestic index balanced portfolio is down a little less than 1% for the year through October 24th. A global balanced portfolio is down more – around 4%. But that’s not catastrophic either.

Also, the historical “standard deviation” or volatility of a moderate or balanced allocation has been around 10%. That means investors can expect a range of returns within 10 percentage points in either direction around such a portfolio’s average return of 7% per year. So far, we are within that tolerance. And standard deviation isn’t perfect; it only captures most of the deviations around the average return, not all of them. There are times when balanced portfolios will have a wider range of return including losses than a 10 percentage point deviation around the average return. But we are nowhere near these larger losses yet.

Here, again, investors may be fooled by recency bias. Morningstar’s moderate allocation category has delivered a standard deviation of over 9% for 15 years, but only around 6% or one-third less for 3 years.


Overall, investors should remember that although October has been a bad month, the volatility we’ve experienced over the past few years is well below average. October has been a reminder that volatility is part of the “price of admission” to the financial markets.

Analyzing This Year’s Market Returns

Many investors assume their accounts have achieved good returns this year. After all, the S&P 500 Index is up nearly 9.5% through October 8, including dividends. But that doesn’t necessarily mean your account has an inflation-beating return for the year depending on your bond and international stock exposure.

And while bonds and foreign stocks have been drags on portfolios this year, owning them is no reason to change your allocation. But now is a good time for a portfolio assessment or a moment of understanding what you own and why – and how asset class returns have diverged this year.

A Tale of Two Balanced Portfolios

Let’s say you’re a balanced investor (around 60% stocks and 40% bonds) and you have all your money in one fund – the Vanguard Balanced Index fund (VBINX). That fund keeps 60% of its assets in U.S. stocks and 40% of its assets in U.S. bonds, and it’s up 4.29% for this year through yesterday. That’s a decent return, but it seems far away from the 9.5% return of U.S. stocks.

If you’re guessing that bonds have been a drag on portfolios this year, you’re right. The Bloomberg Barclays U.S. Aggregate Index, the main U.S. bond benchmark is down 2.53% for the year. When 40% of your portfolio is down it will necessarily damp the effect from the part of the portfolio that has done well. And while that can make you wish you didn’t own any bonds, your bonds will save you the next time the stock market tanks – especially if they are government bonds. A 100% domestic stock portfolio – especially when the S&P 500 is trading at expensive valuations – probably isn’t a good idea for any investor. Most people can’t handle the volatility of a 100% stock portfolio even when the market is cheap on reliable long-term metrics like the Shiller PE. And you own bonds as a kind of insurance policy that happened not to pay off this year. That’s fine; you’re not supposed to make an insurance claim every year. So if you’ve captured a 4% return from your balanced portfolio so far this year, that’s a good return.

If you own a balanced portfolio that’s diversified into international stocks, your returns are less appealing (though still not awful). That’s because the global stock market, measured by the MSCI ACWI Index, is up only 1.56%, a far cry from the 9.5% return of the S&P 500 Index. International stocks, both developed country and emerging markets, have posted losses this year in U.S. dollar terms. And since U.S. bonds are down 2.53%, a balanced portfolio of global stocks (assuming unhedged currency exposure) and domestic bonds is down 0.76% for the year. That’s a modest loss, but any loss feels worse than a 4.29% gain or a 9.5% gain.

But, again, nobody should make dramatic changes to their portfolios or fire their advisor if their balanced portfolio has posted a loss. Many good investors have argued that foreign stocks are cheaper than U.S. stocks. They are likely to outperform over the next 7-10 years, so there’s a good reason to hold them. Also, as recently as last year, international stocks outperformed U.S. stocks. In 2017, the S&P 500 Index delivered a 22% return including dividends. But the MSCI EAFE Index for developed country foreign stocks returned 25% and the MSCI EM Index for emerging markets stocks returned a whopping 37%, both in U.S. dollar terms. So sometimes diversification benefits you, and sometimes it doesn’t. Sometimes owning a cheaper asset doesn’t pay off immediately. And it could happen that international stocks outperform domestic stocks next year again, despite a slowing global economy and currency issues for emerging markets due to a rising U.S. dollar. As it happens, Lance Roberts, who manages portfolios at Clarity Financial, has avoided international stocks for most of the year, and that has been a benefit to portfolios. He has written about his avoidance of international stocks here.

Above all, remember also that you’re not in this for one year’s worth of returns. It’s true that analysts and pundits focus on ridiculously long periods of time that no normal human being has for investment purposes – 100 years, for example. But you don’t have one year either if you have stock exposure. You probably have at least 10 years, maybe 20, and possibly even 30, if you’re about to retire. That doesn’t mean poor years should be taken cavalierly, especially early in retirement. But If you have bond exposure and international stock exposure, understand why you have them and that it’s not always easy to predict how any asset classes will perform from year to year.

Overall, if you have any kind of positive return from a balanced portfolio this year, you’re doing reasonably well. Please feel free to contact us if you have questions about this year’s returns, asset allocation, or retirement planning.

The Two Rules Of “Stockbroker Economics”

How an advisor should talk to clients and what rhetoric leads to big sales are often at odds. It can be death to an advisory business if the advisor is negative. Clients tend to want reassurance from an optimistic advisor. That’s why economist Andrew Smithers refers to broker happy talk asstockbroker economics.”

The two rules of stockbroker economics are:

1. All news is good news, and;

2. It’s always a good time to buy stocks.

On the role of news, a strong economy fills clients will all the optimism and willingness to buy that they need. A weak economy simply prompts a broker to say that falling interest rates and future rising profits are good for stocks, never mind that profits and prices had only moved in tandem 54% of the time when Smithers wrote his 2006 article. On the second rule, nothing has succeeded as well as what Smithers calls the “bond yield ratio,” another name for which is the “Fed Model.” That model compares bond yields to the earnings yield of the stock market (the reciprocal of the P/E ratio or E/P). This ratio worked from 1977 to 1997, but didn’t from 1948 to 1968. Using the full dataset shows no relationship between bond yields and earnings yields, according to Smithers.

Other forms of nonsense used to support the second rule include using a current P/E ratio to appraise stocks. Of course, a current P/E ratio has little ability to forecast long-term returns. It sometimes shows stocks are expensive when they are actually cheap, and vice versa.

A third piece of nonsense that Smithers doesn’t mention is the assertion that all forecasting is bunk. While forecasting next year’s returns might be bunk, metrics like the Shiller PE and Tobin’s Q have strong records in forecasting future long-term returns. Even if the Shiller PE has been elevated for the past 25 years, the S&P 500 Index has delivered tepid returns (5.4% annualized) from 2000 through 2017 with the entirety of that return occurring only in the last 5-years.

All of this means the first rule for investors judging their advisors is whether their advisors engage in too much happy talk – especially about future returns. If an advisor says a balanced portfolio should deliver a 7% annualized return for the next decade with starting 10-year U.S. Treasury yields at 3% and stocks at a 32 CAPE, be wary.

Second, investors should avoid advisors who avoid making forecasts to the point where they disparage anyone who does. That’s because it’s not hard to make a bond forecasts. With high-quality bonds, yield-to-maturity will get you close to the total return. Although stocks are harder, the Shiller PE can help. And, the more it’s stretched by historical standards, the more accurate it gets. No advisor should be dogmatic about pinpointing future returns; anyone who thinks they can be precise is crazy. But it’s also outlandish to expect long term historical returns from the stock market when valuations are as stretched as they are today. Stock market forecasts are hard, but don’t let your advisor squirm out of them completely.

Making a forecast is also necessary for constructing a financial plan. And, while it’s true that an accurate forecast doesn’t have to be available just because advisors and clients need one, decade-long projections are easier, if imperfect, than guessing what next year’s market move might be. When the Shiller PE stretches to more extreme levels, low future returns become more likely. So, when you hear an advisor making fun of something, that should raise warning flags.

We think advisors with integrity aren’t afraid to tell clients stocks are expensive even when it might hurt the advisor’s business. An advisor constructing a financial plan owes you an honest assessment of future returns. Currently, the Shiller PE is at 32. And while nothing is impossible, it’s very unlikely that stocks will deliver more than a 2% real annualized return for the next decade.

Third, consider if your advisor goes beyond the risk questionnaire he gives you. Nearly every financial advisory firm has a risk questionnaire that it gives to prospects and clients. The questionnaire often has many questions about how much risk the investors think they can handle and what portion of their assets they’d like to put at risk in exchange for possibly getting a higher return than a low risk investment will deliver. But risk questionnaires ask about percentages, and most people don’t think in percentages. Consider if your advisor asks you how you might feel if you opened up your statement and your account was down by a certain dollar amount. That’s more meaningful than a percentage question. Consider it a positive thing if your advisor pursues this line of questioning a bit, including asking you how you felt and how you reacted to the market plunge in 2008.

Risk often boils down to how much of a portfolio decline a client can tolerate before selling out, and everyone has a point at which they sell. This is important because it shows how investors do themselves damage. The tendency should be to buy stocks when they get cheaper, not sell them. But investors rarely think of buying when the prices of their holdings are declining.

Advisors have other ways of trying to train clients about how to treat price declines in their portfolios. Many advisors focus on long–term asset class returns, trying to persuade investors that they can overcome declines if they have the willpower to stay the course and not be discouraged. Other advisors do the opposite, focusing on how severe declines can be and trying hard to get clients into allocations that they can live with at the outset and to prepare them for the difficulty that lies ahead in the inevitable downturns.

The advisors who emphasize long term returns often come close to shaming clients into owning stocks. In my experience, such has made some clients feel inadequate for not wanting to assume more risk – or have encouraged clients to take more risk than they would have for fear of being deemed inadequate in the eyes of the advisor. Make sure your advisor isn’t shaming you into owning more stocks than you can handle.

At Clarity Financial, we focus on the growth of savings and on the minimization of emotional duress that can lead to poor investment decision-making.

It’s Okay To Hold Some Cash

The great sage and baseball legend, Yogi Berra, once said:

“It’s tough to make predictions – especially about the future.”

But financial planning is all about contemplating how much money will result from a particular savings rate combined with an assumed rate of return. It’s also about arriving at a reasonable spending rate given an amount of money and an assumed rate of return. In other words, plugging in a rate of return is unavoidable when doing financial planning. Perhaps financial planners should use a range of assumptions, but some assumption must be made.

The good news is that bond returns stand in defiance to Berra’s dictum; they aren’t too difficult to forecast. For high quality bonds, returns are basically close to the yield-to-maturity. Stock returns are harder, but there are ways to make a decent estimate. The Shiller PE has a good record of forecasting future 10-year stock returns. It’s not perfect; low starting valuations can sometimes lead to low returns, and vice versa. But it does a decent job. And the further away the metric gets from its long-term average in one direction or another, the more confident one can be that future returns will be abnormally high or low depending on the direction in which it has veered from its average. Currently, the Shiller PE of US stocks is over 30, and its long term average is under 17. That means it’s unlikely that future returns will be robust.

The following graph shows end-of-April return expectations for various asset classes released by Newport Beach, CA-based Research Affiliates. One will almost certainly have to venture overseas to capture higher returns. And those likely posed for the highest returns – emerging markets stocks – come with an extra dose of volatility. Along the way, there will be problems caused by foreign currency exposure too, though Research Affiliates thinks foreign currency exposure will likely deliver some return.

Hope for a correction? Move some money to cash?

Given this return forecast, investors will have to contemplate saving more and working longer. But investors who continue to save should also hope for a market downturn. As perverse as that sounds, we are in a low-future-return environment because returns have been so good lately. We have basically eaten all the future returns over the past few years. And nothing will set up financial markets to deliver robust returns again like a correction. That’s why the Boston-based firm Grantham, Mayo, van Otterloo (GMO), which views the world similarly, though perhaps a bit more pessimistically, to Research Affiliates has said that securities prices staying at high levels represents “hell,” while a correction would represent investment “purgatory.” If prices stay high, and there are no deep corrections or bear markets, there will be little opportunity to invest capital at high rates of return for a very long time.

Investors who aren’t saving anymore should hold some extra cash in anticipation of purgatory. If we get purgatory (a correction) instead of hell (consistently high prices without correction), the cash will allow you to invest at lower prices andva higher prospective return. How much extra cash? Consider around 202%. The Wells Fargo Absolute Return fund (WARAX) is run by GMO, and 81% of its assets are in the GMO Implementation fund (GIMFX). Around 6% of the Implementation fund is in cash and another 16% of the fund is in U.S. Treasuries with maturities of 1-3 years, according to Morningstar. So more than 20% of the Implementation fund – and nearly 20% of the Absolute Return fund — is in Treasuries of 3 years or less or cash.

Around 52% of the Implementation fund is in stocks, most of them foreign stocks. So around 40% of the Absolute Return fund is in stocks. (The other holdings of the Absolute Return fund are not invested in stocks as far as I can tell.)

If you normally have something like a balanced portfolio with 50% or 60% stock exposure, it’s fine to take that exposure down to 40% right now. There is no question that this is a hard game to play. The cheaper prices you’re waiting for as you sit in short-term Treasuries or cash, with roughly one-third of your money that would otherwise be in stocks, may not materialize. After all, as Berra said, “It’s tough to make predictions.” Or the lower prices may materialize only after your patience has expired, and you’ve bought back into stocks at higher prices just before they’re poised to drop.

These adverse outcomes are real possibilities. But the buy-and-hold, strictly balanced allocation (60% stocks/ 40% bonds) also isn’t easy now for those who (legitimately) fear a 30+ Shiller PE. That’s why it’s arguably reasonable to move some of your stock allocation into cash and/or short-term Treasuries, but not the whole thing. And sitting in cash hasn’t been this easy for a decade or more, now that money markets are yielding over 1% and instruments like PIMCO’s Enhanced Short Maturity Active ETF (MINT) are yielding over 2%. Those yields at least act as a little bit of air conditioning if investment hell persists and prices never correct while you sit in cash with some of your capital.

Don’t Expect Another Free Lunch In The Markets

The most recent quarterly letter from Grantham, Mayo, van Otterloo (GMO) contains an interesting argument about bonds. Over the past five years, bonds have provided great performance, but also more diversification from stocks than they have since the Great Depression. That, along with a tamer stock market, has helped balanced portfolios have lower volatility than usual. Indeed the Vanguard Balanced Index Fund (VBAIX) has a five-year standard deviation of 6%, according to Morningstar. Over the longer term, volatility of balanced portfolios has been around 10%.

Ben Inker, author of the letter, argues that if an investor, over the last five years, had wanted to target a volatility of 10% — the historical long-term volatility of a balanced portfolio – such would have entailed a leveraged portfolio of 143% stocks, 96% bonds, and -139% cash. Moreover, levering up a balanced portfolio 139% would mean achieving returns of more than 7% annualized over cash, according to GMO’s asset class return forecast.

But Inker isn’t advocating using such leverage, as so many “risk parity” portfolios do. This situation amounts to a free lunch that Inker doubts will persist into the future. It’s possible that risk and risk premia have fallen so that levering up to achieve returns is less dangerous than it used to be. But it’s more likely that the recent “easy” environment is a temporary one in Inker’s opinion. As he puts it:

”Even if the natural volatility of the economy has fallen over time and even if policy response is better than it was 80 years ago, neither markets nor economies are all that well-behaved. Stability breeds instability, as Human Minsky pointed out 40 years ago.”

Why do stocks usually have a premium over bonds?

To arrive at his conclusion, however, Inker recounts some recent history, reminding readers of the basic difference between stocks and bonds along the way.

First stocks are riskier to buyers than issuers. Companies can go bankrupt, after all, and the equity is usually worth nothing in that instance. But, according to Inker, that “idiosyncratic risk” is not why stock investors have achieved such a premium historically. The other reason why stocks typically offer a long term premium over bonds is that equity losses occur at exactly the moment it is most painful to own them.

After all, stocks usually go down when the whole economy goes down. So, if you have a stock-heavy portfolio, your portfolio is likely to tank exactly when you lose your job, compounding your misery.

However, if fears of economic downturns have diminished, then the risk premium that stocks usually have over bonds might dry up. It wouldn’t make sense for stocks to offer higher long term returns in an environment that suddenly became safe and free from recessions. And Inker argues that’s what happened right before the Financial Crisis. Riskier assets were poised to deliver lower long term returns than less risky assets. And as much of a shock as the crisis was to this point of view:

“The rapid recovery corporate cash flow in the aftermath and the consequent lower levels of distress than previous cycles experienced have served to assuage investors’ economic concerns.” 

The passage of time from the last crisis has also convinced today’s investors that they could withstand a new one regardless of how they behaved last time.

Not only have fears of economic downturns receded, but it has seemed easier than ever to protect portfolios. High quality bonds did their job in the last crisis (provided you held enough of them). Recessions help high quality bonds in two ways: deflation makes existing coupons more attractive, and central banks lower rates.

What has made bond performance (and bonds’ low correlation to stocks) so astonishing in recent years is that bonds have posted great returns in the absence of a recession. Bonds are not supposed to behave quite this well and in quite this uncorrelated fashion from stocks in non-recessionary environments. Don’t look for that negative correlation to continue, and don’t try to juice your returns by levering up a balanced portfolio.

Projections Are Imprecise, But Not Useless

It seems banal to say, but financial planning requires return projections or estimates. If you’re saving money for a goal like retirement, sending a child to college, buying a home, or taking a vacation, you need to know three things (at least) — how much to save, how much of a return that savings will earn, and the distance to the goal. Without any of those three things, there can’t be a plan. And all of this doesn’t take into consideration your own temperament or how you react to volatility and the potential for permanent loss.

Of course, the return projection won’t be precise if any part of the capital is being invested in stocks. It’s not easy to forecast how much stocks will return over a given time, and the shorter the distance to the goal the more unpredictable and random stock returns are. And that’s one reason stocks shouldn’t be used for short-term financial goals. They can do virtually anything over one- or two-year periods of time. However, over longer time frames — 7-10 years or more – forecasts can be more reasonable, though still not precise. But one is never absolved from making an estimate or a range of estimates.

Unfortunately, some prominent financial planners, who often double as pundits, denigrate all forms of forecasting. Financial planner and sometimes New York Times columnist Carl Richards recently tweeted that the only thing we know about projections is that they are wrong. He applied the hashtag “projectionfreeplanning,” which, of course, is an oxymoron. There’s no such thing as financial planning or projecting a future value of an investment, after all, without a return estimate.

Similarly, prominent advisor and pundit, Barry Ritholtz, has argued that forecasting is “almost useless” and that we “stink at it.” Ritholtz says assertions like “stocks tend to go higher” are vague enough to be exempted from his critique, but “The Dow will hit 25,000 by the second quarter of 2018” aren’t. What’s frustrating about his writings is that they don’t say anything about the ordinary forecasting of long term (say, 10- or 20-year) returns financial advisors must do to satisfy future value calculations for their clients.

The pundits like to say that the Shiller PE isn’t a valid metric anymore because it’s been well over its long-term average – around 16.5 – for over 25 years. But the annualized return of the S&P 500 Index, including dividends has been 5.4% from 2000 through 2017, and the Shiller PE was over 40 in 2000. In other words, in 2000, it did a good job of telling investors future returns would likely be tepid. Moreover, that return has depended on the dazzling 15% return of the index since the financial crisis that has driven the Shiller PE up again to the low 30s. And, as Rob Arnott has said, we can have a reasonable argument about whether the new normal for the Shiller PE is 20 or 22, but not whether it’s 30.

Advisors are rebelling so much against forecasting because they don’t like to deliver bad news to clients. Bad news can be bad for business. Clients will choose the advisor with the highest future returns projections because they want to be soothed. But delivering optimism when it’s unwarranted can lead to projections that border on malpractice on the part of the advisor. Investment professionals usually know this when it comes to bonds. It’s difficult for a bond or a portfolio of bonds to return more than its yield-to-maturity. However, when it comes to stocks, advisors often resort to using the longest term return numbers they can find. Those usually come from Ibbotson Associates, now a division of Morningstar, which popularized a stock market return chart dating from 1926. But most investors aren’t investing for a century, and there have been enough 10- and 20-year periods of poor returns to give investors and advisors pause. More importantly, those periods are associated with high starting valuations.

And now it has become clear that estimating, say, 7%, for a balanced portfolio over the next decade is a stretch. Bonds are likely to deliver less than 4%, and that means stocks will have to deliver more than 8.5%. Advisors are becoming increasingly pessimistic about that possibility for stocks, but they aren’t responding by expressing that pessimism clearly Instead, they are responding by bashing forecasting altogether. It’s not the most mature response, but the possibility of losing clients because of poor forecasts has its bad effects. And it’s true that the Shiller PE — or any other valuation metric — isn’t perfect in forecasting returns, but it can’t be prudent to count on stocks delivering 8.5% for the next decade with a starting Shiller PE in the low 30s.

Investors should question their advisors about returns, because they need to know how much money their current savings rate will leave them with to spend in retirement. The return assumption is just that — an assumption — but that means investors can ask for a range of assumptions to see what different returns will deliver. That doesn’t mean the optimistic assumptions are truer ones though, but it helps investors understand what they’re up against without being precise. And that is far from useless. The second thing investors should do is something financial journalist Jazon Zweig discussed in an old column – they should ask their advisors how much return the advisor would deliver to the client in a “total return swap,” whereby the client hypothetically hands over their entire portfolio and gets an annualized return on that portfolio in exchange. There’s no better way to put the screws to your advisor when it comes to getting his or her opinion on future returns.