Archives for May 2009

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What stock market return should we expect?

One benefit of Oblivious Investing is that you can take an “I don’t know, and I don’t care” attitude about market swings and short-term market results. It’s quite freeing when compared to investment strategies that put you at the mercy of the month-to-month whims of the investing public.

Long-term market returns, however, are another story. There’s simply no way to create an investment plan without using something as your projected rate of return.

In other words, while, “I really can’t say for sure.” is the most truthful market prediction anybody can give, it’s also entirely unhelpful.

Darn.

My best guess

The three primary determinants of market return are:

  1. Dividend yield
  2. Earnings growth, and
  3. Shifts in market P/E ratios (caused by changes in the demand for stocks).

Historically, over periods of 30 years or more, the first two factors (the more predictable ones) have made up the bulk of the return, while the third factor (the unpredictable one) has performed a much smaller role–generally either increasing or decreasing the annual return by 1% or so.

At the moment, applying this formula indicates that we can expect a 30-year annualized return between 7.5% and 9.5%.

Where things get tricky

The problem, as Carl reminds us, is that you don’t pay your bills with percentages. You pay them with dollars. And while expected annual returns become fairly predictable over long periods, expected total return becomes less predictable.

The reason, of course, is that a slight change in annual return–when compounded over multiple decades–causes a dramatic change in ending value.

For example, if an investor plans on 40 years of 10% returns, and she gets 40 years of 9% returns, she’ll have only 76% as much money as she planned on having–even though her estimated annual return wasn’t too far off.

So what should we plan on?

Naturally, the prudent thing to do is plan on a conservative rate of return. For example, based on the “dividend yield + earnings growth” formula mentioned above (often called the “Gordon equation”), I’d currently plan on a 7.5% annual rate of return over the next few decades.

(And for any period shorter than a few decades, my answer is still a stubborn “I have no idea.”)

Ongoing (infrequent) monitoring

At least as important as what return you should plan on earning is the question of how to monitor the return you’re earning to see if it’s living up to your expectations. In my opinion, an annual checkup–done at the same time as your annual rebalancing–should be quite sufficient.

If, when looking at your portfolio’s 5-year or 10-year returns, it appears that you’re falling short of your estimates, it’s time to either step up your contributions or adjust your goals.

You’re Below Average. (And so am I.)

There. I said it.

You’ve probably spent your whole life learning that you have above-average intelligence and above-average work ethic. And, when considering the entire population of people around you, that may very well be true.

But if you plan to pick stocks (or do anything else to beat the market), the group that you’re being compared to is no longer same group. The fact that you’ve been above average at everything else in your life doesn’t necessarily mean much here, because the same thing is true about your competitors.

More important, though, is the fact that this isn’t just about intelligence.

It’s about resources.

Time: They have more of it. They do this full-time. You probably don’t.

And if you’re currently thinking “Sure, I do this in my spare time, but I still work on it for roughly 40 hours a week,” you’re kidding yourself. I’d be surprised to hear of very many fund managers who call it quits after putting in a 40 hour week.

Data: They have more of it. There’s nothing that you can find in your Motley Fool newsletter or Morningstar subscription that they don’t have access to as well.

News: They get it sooner. Many of your competitors are literally on the floor of the NYSE. When something starts to happen, they can react far more quickly than you can.

Don’t worry. I’ve got some good news too.

The good news is that you don’t have to beat the market to be a successful investor. (This concept doesn’t get nearly enough media coverage.)

It seems to be a pretty safe bet that the businesses in our global economy will continue to earn a net profit for the foreseeable future. Capture your share of that profit, and you can build a great deal of wealth.

For the most part, all you have to do is invest regularly, select an appropriate asset allocation, diversify within asset classes, minimize costs….and then not screw up by bailing out on your plan.

Added bonus: It’s actually less work to match the market than it is to underperform it. 🙂

The downside to passive investing.

In the last few weeks, a handful of people have asked to see a greater discussion of the drawbacks to passive investing. I’ve been thinking about it a lot. So here we go…

  1. It’s boring.
  2. There’s precisely zero chance that you’ll get rich overnight.
  3. It’s difficult. (Not the mechanics of it–those are quite simple. The hard part is sticking it out through a down market.)

From my perspective, that about covers it. 🙂 Anybody have anything they want to add?

Ways to Improve Investment Return

Nobody wants to be–or thinks they are–average.

When it comes down to it, I think that’s the only reason that low-cost passive investing isn’t enthusiastically used by every investor out there. People have a tendency to believe that they–or somebody acting on their behalf–will be able to outperform the market, whether by earning a greater return or by matching the market’s return while incurring less volatility.

However, with every transaction that occurs in the stock market, two things are true:

  1. One of the two parties is buying an investment that will underperform (or selling an investment that will outperform) and is thereby decreasing his total return relative to the market, and
  2. The total return by the group (that is, both investors considered together) is decreased by an amount equal to the transaction costs incurred.

Most books/articles about investing tend to focus on point #1 above and how to make sure you’re not the one getting the short end of the stick, so to speak.

Truth be told, I have yet to see anything that convinces me that an individual investor has any advantage whatsoever over the institutional investors who are likely to be on the other end of most transactions.

As a result, I find myself more interested in point #2 and what we can do to improve the total return earned by investors as a group. It seems to me that it would be beneficial for our society as a whole to spend more time discussing this topic and a great deal less time discussing the first.

How we can improve our total performance:

Cut costs! Common sense would indicate that, as a group, the best return we can possibly hope for is the return earned by the assets in which we’re invested. So we might as well seek to minimize costs and come as close as possible to earning a return equal to that of the market, right?

A few ways we can do that:

As far as I can tell, that’s it. Anyone have any other ideas?

A few questions for you…

In an effort to help improve the blog and determine its future direction, I’ve put together a short survey to help me see exactly what it is that you’d like to read about/discuss.

It’s 5 questions in total, so it won’t take more than a couple minutes. (Also, it doesn’t ask for any identifying information.)

Click here to take the survey.

Thanks for your time. I really do appreciate it. 🙂

How does rebalancing affect return?

I recently came across an article from William Bernstein explaining how periodic rebalancing is likely to affect the return in your portfolio.

The language in the article is a bit technical, but the message is important. The following is my attempt to put it in everyday terms (with some of my own explanations/interpretations mixed in).

What we’d expect: weighted-average returns

Imagine a portfolio made up of a 75/25 allocation between a stock index fund and a bond index fund.

If, over the next 10 years, the stock market were to earn an 8% return, and the bond market were to earn a 4% return, we might expect the portfolio (with its 75/25 allocation) to earn a return equal to the weighted average of the two–a 7% return.

Weighted Average Return = .75 (8%) + .25 (4%) = 7%

If the portfolio is rebalanced regularly throughout the 10-year period, however, the results are different. In fact, in most cases, the portfolio ends up earning a return that’s slightly greater than the weighted-average return of its components. (Bernstein refers to this additional return as the “rebalancing bonus.”)

Why does this happen?

In short, it’s because regular rebalancing is a way to force yourself to buy low and sell high.

The idea is that decreasing your exposure to the portion of your portfolio that’s just performed best, while increasing your exposure to the portion of your portfolio that’s underperformed should improve your performance. It doesn’t always work, but apparently it works more often than not.

How much additional return can we get?

Well, that depends on a couple variables. Specifically, it depends upon:

  • The volatility of each of the asset classes, and
  • The correlation between the two asset classes.

In order to maximize the rebalancing bonus, we want the volatility of each asset class to be high, and we want the correlation between the two to be low.

How we can profit from this information

It’s common sense that we can reduce portfolio volatility by adding an asset class that has little correlation to the rest of the portfolio. What’s fascinating to learn is that if the asset has an expected return equal to the rest of the portfolio, including it in the portfolio would not only decrease volatility but probably increase return as well.

Alternatively, if the asset has an expected return that’s less than the rest of the portfolio (as would be the case with adding a bond component to a stock portfolio), including it in the portfolio is unlikely to decrease expected return as much as we’d intuitively expect.

In other words, some of the return we sacrifice by including an asset class with a lower expected return than the rest of the portfolio is made up for in the form of a rebalancing bonus.

Takeaway #1: When constructing a portfolio, the correlation of the asset classes involved will affect not just your portfolio volatility, but your overall return as well.

Takeaway #2: Any asset that’s both highly volatile and uncorrelated to the stock market (gold, for instance) can make a lot of sense as a small portion of a portfolio due to the fact that it’s likely to contribute a greater return for the portfolio than would be indicated by the asset’s stand-alone return.

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