5% Future L/T Real Returns?

[mickeyd]

Article suggests that future long term real rate of return of the US stock market is really 5%. Says that Jeremy Siegel was too optimistic at 7%. This study used earnings yield to forecast future stock market returns.

But clearly, the stock market does not provide a consistent return every year. If you expect to get Siegel’s 7% year-in and year-out, or any other static return number for that matter, you will be very disappointed. Sometimes the return of the stock market is higher and sometimes it is lower, but it is rarely, if ever, equal to its long-term historical average.

Our research suggests, instead, that the future long-term real rate of return of the U.S. stock market is actually closer to 5%. This conclusion does not flow from a more granular slicing and dicing of historical data. Rather, it flows from our effort to identify a reliable method for finding future expected returns when markets are always changing. Our goal was to find a better way than to simply use historical averages.

The starting place for our quest was the Gordon growth model, a classic model for fundamental stock valuation. Our examination of that model led us to conclude that the earnings yield (the inverse of the more popular price-to-earnings ratio) might provide a good estimator of future stock market returns.

Reasonable Expectations

 

[IBWino]

Thanks for the link. From the article (very interesting stuff):

The second time period was March 1961 through January 2010. The P/E 10 at the beginning and end of the period was 19.6, while the average annual P/E 10 through these years was 19.4. This translates into an earnings yield of 5.1%, so if this is a good predictor of future real returns, we would expect to see annualized real returns of about 5.1%. The actual return during that period was 5.0%—very close.

We believe people’s expectations about real return for the U.S. stock market shifted during these periods. We are not entirely sure why, but we surmise that investors simply came to see stocks as less risky than they had been, and ultimately this perception was correct. The standard deviation of U.S. stocks from 1926 through 1954 was 29.6%, but it was only 16.3% from 1961 through 2012. Perhaps the advent of modern portfolio theory caused people to realize that the volatility of a single stock could be offset by combining it more scientifically with a basket of other stocks. Maybe the increase in U.S. government spending following World War II and the emergence of the U.S. as a major economic power assured people that the economy would be more stable in the future.

Whatever the reasons, beginning in 1961 (after an apparent six-year transition period), stocks were priced as though they were less risky. Because they were.

One good thing about FireCalc is that it encompasses these previous periods of lower real returns.

 

[siamond]

For one bear-ish opinion like that, we'll hear one bull-ish opinion predicting 9%... Which may sound equally convincing... Fact is nobody knows.

I don't know, I'd rather stick to Firecalc-like modelling as a basis, use common-sense investing (e.g. passive/low-fees, stick to my diversified asset allocation), and see what goes, while adjusting my annual income based on my current capital. Seems to me it's equally important to live well if things go well as to be careful and tighten the belt when things go sour.

That's the problem with doomsayers, we have only one life, so better not take them as face value, you never know, things MAY go well!

 

[FIRE'd@51]

Jeremy Siegel expects some multiple expansion, although I don't see where it's going to come from since interest rates are already very low and are likely to rise. Since the dividend yield on the S&P 500 is about 2%, we would need real growth of dividends of about 5% to get to a 7% real return long-term without multiple expansion.

 

[FinancialDave]

For one bear-ish opinion like that, we'll hear one bull-ish opinion predicting 9%... Which may sound equally convincing... Fact is nobody knows.

I don't know, I'd rather stick to Firecalc-like modelling as a basis, use common-sense investing (e.g. passive/low-fees, stick to my diversified asset allocation), and see what goes, while adjusting my annual income based on my current capital. Seems to me it's equally important to live well if things go well as to be careful and tighten the belt when things go sour.

That's the problem with doomsayers, we have only one life, so better not take them as face value, you never know, things MAY go well!

+1

fd

 

[photoguy]

For one bear-ish opinion like that, we'll hear one bull-ish opinion predicting 9%... Which may sound equally convincing... Fact is nobody knows.

The 5% forecast is way more convincing to me. It has more support based on studies which look at PE10 and predictive returns. However the studies also suggest a very wide variance in returns.

 

[bUU]

I'm getting to the point where it isn't spending or lack of income that is resulting in our retirement plan failure, but rather it is increasingly pessimistic predictions of future returns on investments that is doing that. I had worried that I wouldn't be able to keep ahead of inflation - now I'm worried that I cannot keep ahead of progressively bearish prognostication. I'm especially worried that such prognostication becomes self-fulfilling.

 

[BigE]

For one bear-ish opinion like that, we'll hear one bull-ish opinion predicting 9%... Which may sound equally convincing... Fact is nobody knows.

I don't know, I'd rather stick to Firecalc-like modelling as a basis, use common-sense investing (e.g. passive/low-fees, stick to my diversified asset allocation), and see what goes, while adjusting my annual income based on my current capital. Seems to me it's equally important to live well if things go well as to be careful and tighten the belt when things go sour.

That's the problem with doomsayers, we have only one life, so better not take them as face value, you never know, things MAY go well!

++1. Very well said. Although there seems to be significant evidence of lower returns going forward, as prognosticated by a number of persons generally respected on this and the Boglehead forum, a recurring mantra from this same group is that NO ONE knows, it's a "random walk", and don't put much faith in predictions. So yeah, I'm going to tune out the noise and stay the course and be as practical as I can with the spending side of the equation.

 

[Huston55]

I'm getting to the point where it isn't spending or lack of income that is resulting in our retirement plan failure, but rather it is increasingly pessimistic predictions of future returns on investments that is doing that. I had worried that I wouldn't be able to keep ahead of inflation - now I'm worried that I cannot keep ahead of progressively bearish prognostication. I'm especially worried that such prognostication becomes self-fulfilling.

How do you think this would happen; that it becomes "self fulfilling?"

 

[bUU]

People hear it, and it affects their investing behaviors.

 

[Huston55]

People hear it, and it affects their investing behaviors.

Wouldn't you expect that to be a temporary, short term effect?

 

[harley]

5% real still allows for a 4% SWR while keeping up with inflation. While it's not ideal, it would be good enough for me.

 

[photoguy]

The other thread suggests that dropping expected returns to 5% greatly magnifies failure rates (e.g., 40-60 portfolio sees an increase from 5% to 20%) due to the sequence of returns issue.

 

[Which Roger]

Investors will only accept lower expected returns if they also feel that the investment is less risky. A less risky investment has a lower standard deviation of returns from year to year, lessening the likelihood of a very bad sequence of returns early in the withdrawal phase that dooms the portfolio to failure. So any tool or model that predicts success/failure rates should adjust the standard deviation accordingly if the assumption is that returns going forward will be different than in the past.

 

[haha]

Investors will only accept lower expected returns if they also feel that the investment is less risky. A less risky investment has a lower standard deviation of returns from year to year, lessening the likelihood of a very bad sequence of returns early in the withdrawal phase that dooms the portfolio to failure. So any tool or model that predicts success/failure rates should adjust the standard deviation accordingly if the assumption is that returns going forward will be different than in the past.

For people who already have invested a good portion of their lifetime money available for investment it won't matter what people will accept-they'll have to accept whatever they get. That seems hard for people to get-once you deploy your money, absent successful market timing you've bought it.

Only exception is if much is invested in relatively short duration high quality bonds. Buying a diversified portfolio of stocks is like buying a long term zero. Stocks have an indeterminate but perhaps unbounded maturity, and unless they are bought with very high dividends, also a very long estimated duration.

Ha

 

[bUU]

Wouldn't you expect that to be a temporary, short term effect?

Everything is temporary. This, I suspect no more so than anything else, though.

 

[jebmke]

5% real still allows for a 4% SWR while keeping up with inflation. While it's not ideal, it would be good enough for me.

I guess it depends on how much equity you hold.

 

[photoguy]

Investors will only accept lower expected returns if they also feel that the investment is less risky. A less risky investment has a lower standard deviation of returns from year to year, lessening the likelihood of a very bad sequence of returns early in the withdrawal phase that dooms the portfolio to failure.

This statement sounds reasonable but is there any data to support it?

It seems to me that the dot com crash is a counter argument. I.e., PE10 hit 45, hence expected returns were very low and this was followed by a huge amount of downward volalitity.

 

[FinancialDave]

This statement sounds reasonable but is there any data to support it?

Sure there may be data to support it, but does that make it true - NO!

No one here can predict the future and just because an investment has had a certain Standard Deviation or risk in the past tells you nothing for certain about the future.

What is a little more certain (but still not a given) is that if you invest in a good index representation of the "total stock market" you will make the returns associated with the "total stock market" less any expenses.

fd

 

[almost there]

Not easy to say looking at the giant W on the 20 year S&P chart.

 

[photoguy]

Sure there may be data to support it, but does that make it true - NO!

I'm really looking for data that would support (or refute) WhichRoger's hypothesis in a statistical sense. It would be simple to do something like Schiller's PE10 analysis except instead of 10 year future returns, one looked at 10 year volatility.

No one here can predict the future and just because an investment has had a certain Standard Deviation or risk in the past tells you nothing for certain about the future.

There's a huge gap between "certain" and "having totally no clue" that you can drive a truck through with statistical models.

 

[bondi688]

Not easy to say looking at the giant W on the 20 year S&P chart.

S&P 500 Index (1960 - Present Weekly) - Charting Tools - StockCharts.com


How about shifting your reference to 30 years if you want to cherry pick?

 

[almost there]

S&P 500 Index (1960 - Present Weekly) - Charting Tools - StockCharts.com


How about shifting your reference to 30 years if you want to cherry pick?

Not cherry picking. How about the DOW 1900 - 2013?
Dow Jones Industrial Average (1900 - Present Monthly) - Charting Tools - StockCharts.com

 

[AndrewJackson]

5% would be an awesome real return. I am planning for 3% real return personally. At the end of the day, all we can do is save as much as possible and let the chips fall where they may.