Investors harboring overly optimistic views regarding market returns could be setting themselves up for a rude awakening. Consider this:
Despite wavering consumer confidence in the economy, individuals retain a remarkably bullish outlook on the stock market. According to a recent survey by the Conference Board, expectations for stock price appreciation over the next year are hovering close to all-time highs.
After enjoying a decade of robust 12% returns, it’s natural for optimism to cloud judgment about future prospects. A case in point emerged during a recent conversation with an individual seeking a review of their retirement financial plan. This plan, generated through a standard software program, factors in income, assets, pensions, and social security to project future asset values and retirement withdrawals.
The primary flaw lies in the plan’s exaggerated return assumptions.
Most of these plans hinge on the assumption that individuals will garner a yearly return of 6-10% pre-retirement and 4-8% post-retirement. However, the glaring issue is that lofty returns do not materialize over time – a point that cannot be stressed enough. There exists a significant variance between AVERAGE and ACTUAL returns on invested capital. Profound losses in any given year erode the compounded effects of money.
The graph below illustrates the disparity between “actual” and “average” investment returns. Notice the stark contrast between the purple-shaded area, denoting an annual average return of 7%, and the market price graph, reflecting the impact of capital depletion on “actual returns.”
Another critical factor is individuals’ anticipated returns over the next 10-20 years, which are currently skewed towards the optimistic end of the spectrum.
This brings us to the heart of the matter that warrants discussion today.
There are two primary reasons why anticipated returns in the coming years are unduly optimistic. The first is a personal issue, while the second can essentially be viewed through a mathematical lens.
The Human Factor
In a 2016 piece, I explored a Dalbar investor study shedding light on why investors perennially falter in the investing realm. As outlined in that article, one of the most substantial roadblocks to long-term investment success is the influence of emotionally-driven investment blunders.
Understanding investor psychology unveils the rationale behind erroneous decision-making, leading to the notorious “buy high/sell low” behavior and a host of other emotional missteps that dilute returns over time.
The study identified nine behaviors that obstruct investors, stemming from their individual experiences and dispositions.
The primary roadblocks for individuals are the “herding effect” and “loss aversion.”
These two behaviors often intertwine, exacerbating the impact of investor errors over time. During periods of market ascent, individuals bolster their belief that the upward trajectory will persist indefinitely. With time, this optimistic sentiment solidifies until the last of the skeptics eventually capitulate as financial markets transition into a euphoric state.
Conversely, as markets decline, the realization dawns that the descent signals more than a mere buying opportunity. Mounting losses stoke anxiety, prompting individuals to cut further losses by liquidating positions.
As depicted in the chart below, this behavioral loop contradicts the fundamental “buy low/sell high” principle.
In conclusion, despite our best intentions, succumbing to emotional biases that pave the way for poor investment decisions seems almost inevitable. Notably, while notions of “buy and hold” and “passive indexing” strategies hold merit over extended periods, few manage to weather the storms and reap the rewards.
The repercussions of these emotion-laden missteps culminate in sustained underperformance against lofty financial projections.
The Numerical Perspective
“But Lance, the market has historically yielded 10% returns on average over the past century, so I should be fine, right?”
Indeed, if one can evade vampirism and steer clear of sunlight, garlic, and crosses, achieving the historical average return over the past 124 years might be attainable. However, for us mere mortals – hence the criticality of “duration matching” – the window between today and retirement to achieve our goals is limited, averaging about 15 years for the majority.
Herein lies the crux of the matter.
While the narrative often touts a prolonged secular bull market, the math indicates a starkly different reality. Importantly, discussions about low future returns do not imply yearly downturns; rather, they signal an extended period of subdued performance.
The charts below delineate the rolling REAL, inflation-adjusted returns over 10 and 20 years, juxtaposed with trailing valuations.
(Essential note: Several advisors/anaylsts frequently emphasize that the market has never logged a negative 10 or 20-year return. However, this nominal view disregards the inflation component.)
From the data, two key takeaways emerge. Firstly, historical records showcase instances where market returns hovered close to zero;
Deciphering Market Valuations and Investor Returns
Market valuations have long served as a beacon for investors, guiding them through financial storms and fair weather alike. Like the seasoned advice of a wise mentor, historical data illuminates the path ahead.
Lessons from History
Valuations have a story to tell, a tale of caution and optimism intertwined. Just as the pages of the classic 1934 textbook “Security Analysis” penned by Benjamin Graham and David Dodd urge us to compare stock prices to earnings over extended periods of not less than five years, the echoes of past market peaks and troughs reverberate through time.
Valuations above 23 times earnings mark the zenith of bull markets, while humble valuations at 7 times earnings or less often herald the dawn of new market cycles. The data dances with narratives of rise and fall, cautioning the vigilant investor.
From the current vantage point, the annals of history whisper forecasts of subdued returns over the next decade and beyond. A mathematical tapestry, woven with the threads of GDP growth, market capitalization ratios, and dividend yields, paints a sobering picture of future market performance.
The Harsh Reality
These projections cast a shadow over the dreams of retirees, leaving them clutching at the fading embers of their financial plans. The promise of financial security wanes in the face of lofty valuations and the lingering specter of emotional decision-making.
As the curtain rises on a stage set by expensive markets and uncertain winds of change, investors are left to ponder the delicate balance between optimism and prudence. Risk, the unsung hero of financial endeavors, beckons from the shadows, reminding us of its intimate dance with loss.
A Cautionary Tale
This is not a lament of doom nor a prophecy of despair. It is a simple truth, a reflection of the immutable laws of mathematics over time. The market, a relentless arbiter of fortunes, will have its say.
As we stand at the crossroads of expectation and reality, let us heed the lessons of the past. The echo of past bear markets reverberates through the halls of time, teaching us that this time is truly “not different.”
Optimism, tempered with prudence, will be the guiding star for those who seek to navigate the tempestuous waters of the market. The third act awaits, and only time will reveal if it holds the elusive charm we seek.