M* "Asset Allocator" tool: low expected annual returns...

[FIREd]

I was using the morningstar asset allocator tool on T Rowe Price and I was surprised at the results:

For VFINX, a proxy for the S&P 500 with 100% allocated to equities, the expected annual return is 7.74%. That's ,I assume, after fees but before tax.

More surprising is how little effect adding bonds to the portfolio had on the expected annual return. For example the expected annual return for my darling fund Vanguard Wellington (65% large cap stock / 35% bonds) was 7.26%, only about 6.2% lower than VFINX. Off course the standard deviation was much lower for Wellington than for VFINX as expected (possible 3 month loss was 14.9% for VFINX Vs. 9.4% for Wellington, a 37% drop due to the addition of bonds).

So what gives? Do they know something I don't know to use expected annual return numbers this low? Clearly it seems like they don't think we will continue to get the often mentioned 10-12% annual returns on stocks in the future. So when planning for retirement should we still be counting on the 8-10% returns that most people and financial planners use or should we count on the much lower numbers that M* uses in this tool?

 

[audreyh1]

I think it is safer to assume lower returns going forward and not count on the 10-12% that happened in the past. If planners are using 8-10% returns, they are doing their clients a disservice. The M* numbers above seem more reasonable.

We've just come out of several decades of P/E expansion. That is unlikely to continue, even though we have already seen some P/E contraction in the 2000s.

Even if we see lower returns going forward, it also may be true that inflation is somewhat lower going forward due to the global economy.

Maybe someone will post some of the real return projections for various asset classes going forward. I don't have a handy link.

And yep, using a balanced approach you can expect to get most of the performance of 100% equity with considerable less volatility/standard deviation. That's why many of us prefer a diversified portfolio.

Audrey

 

[cute fuzzy bunny]

I think anyone planning on getting annualized 10% returns without eating a lot of risk is going to be pretty disappointed.

 

[FIREd]

According to Vanguard, historically a portfolio with my asset allocation returned 9.8% from 1926 to 2006... Now I know that past performance blah blah blah... but I thought I was being conservative using a 8% expected annual return (after fees but before tax) on my 80% stock/20% bond portfolio but it sounds like even I have to lower my expectations... Although when I see that a 65% stock / 35% bond portfolio would still return ~7.3% with much less volatility than my current asset allocation, I am tempted to increase my bond exposure and trade a few tenths of a percent in return for much greater stability...

 

[cute fuzzy bunny]

Theres no shortage of experts with lots of reasonable looking charts and data that suggest that a 3-3.5% return after adjustments for inflation might be pushing it.

On the other hand, one of the better looking arguments complete with case data for severely reduced returns from equities was dated from mid 1997.

If I were him, i'd have taken that down by mid '99, although maybe being 'right' for a few years from 2001-2003 might have emboldened him a bit

 

[Bikerdude]

I think (over time) a 50/50 stock/bond portfolio returns 85% of a 100% stock portfolio. Wellington and D&C have done even better with more risk. Better sleep for some of us.

 

[FIREd]

Theres no shortage of experts with lots of reasonable looking charts and data that suggest that a 3-3.5% return after adjustments for inflation might be pushing it.

Then would a SWR of 4% be really "safe"?

 

[cute fuzzy bunny]

Got a crystal ball?

 

[FIREd]

Got a crystal ball?

No but I've got a magic 8 ball and it says "outlook not so good"...

 

[cute fuzzy bunny]

Try again later...

 

[ESRBob]

FireDreamer,
Vanguard's since-inception return for Wellington (since 1928 ) is 8.48%, after fees, so it seems a little suspect that M*'s model is telling you that this asset allocation will do 7.2% going forward. Maybe they are assuming higher fees? In that case, pocket the difference!

 

[Symbiotic]

Are you they including dividend reinvestment? I thought M*'s returns data usually did include that, but I'm no expert.

 

[FIREd]

Are you they including dividend reinvestment? I thought M*'s returns data usually did include that, but I'm no expert.

I am not sure. There are very few variables you can change in the asset allocator tool and it is difficult to know exactly what they take into account to calculate their estimated returns. But I have to assume that they take dividend reinvesment into account. As you pointed out M* usually uses total return numbers that take into account dividend reinvestment, so it is probably the case here.

Vanguard's since-inception return for Wellington (since 1928 ) is 8.48%, after fees, so it seems a little suspect that M*'s model is telling you that this asset allocation will do 7.2% going forward. Maybe they are assuming higher fees? In that case, pocket the difference!

ESRBob, that was one of the reason I was so surprised by the results. 7.26% return for Wellington seems low ball to me and that is the reason why I concluded that M* must be projecting lower returns in the future. There is nothing leading me to believe that they used anything other than the current ER for Wellington in their calculation.

 

[theoldwizard]

I think anyone planning on getting annualized 10% returns without eating a lot of risk is going to be pretty disappointed.

I concur !

Which is why I tell the "youngsters" (under 50) that 10% return is reasonable and attainable, but they aren't going to get there on CD's and Large Cap mutuals. They need more risk !

 

[rmark]

Using Vanguards Total market funds as a proxy for the market

Total U.S. stock 1/pe = 5.8% - .5% costs = 5.3% net real
Total Int’l stock 1/pe = 6.3% - .5% costs = 5.9% net real
Total U.S. bond % - inflation - .5% costs = 1.4% net real

While no measure of expected returns is very accurate, that’s about what the overall market is priced to return.

 

[kaudrey]

Well, I'm the conservative type when it comes to projecting my numbers, so I use 5%. I've only been projecting for 3 years (I'm 38 and 14 years from FIRE) but I've under-projected so far. I update my spreadsheet with actual numbers each year, and I figure if I hit my FIRE number a few years early - well, so much the better!

Karen

 

[jIMOh]

I was using the morningstar asset allocator tool on T Rowe Price and I was surprised at the results:

For VFINX, a proxy for the S&P 500 with 100% allocated to equities, the expected annual return is 7.74%. That's ,I assume, after fees but before tax.

More surprising is how little effect adding bonds to the portfolio had on the expected annual return. For example the expected annual return for my darling fund Vanguard Wellington (65% large cap stock / 35% bonds) was 7.26%, only about 6.2% lower than VFINX. Off course the standard deviation was much lower for Wellington than for VFINX as expected (possible 3 month loss was 14.9% for VFINX Vs. 9.4% for Wellington, a 37% drop due to the addition of bonds).

So what gives? Do they know something I don't know to use expected annual return numbers this low? Clearly it seems like they don't think we will continue to get the often mentioned 10-12% annual returns on stocks in the future. So when planning for retirement should we still be counting on the 8-10% returns that most people and financial planners use or should we count on the much lower numbers that M* uses in this tool?

I use that tool too, maybe the flaw is you are using an index fund? LOL.

I think using lower expected returns for planning is a good thing to set expectations. Plan for 8%, be happy when it's 10%.

Maybe the M* calculator is using "recent results" more than "long term". 10 year return for VFINX is 7.6% according to morningstar... maybe it's using returns for 10 ytd?

 

[audreyh1]

Then would a SWR of 4% be really "safe"?

1. He was talking about REAL return. The SWR is based on total return which includes inflation.

2. The 4% SWR also assumes dipping into principal. It does not attempt to leave the original portfolio principal intact but instead tries to avoid the portfolio going to 0 under worst case conditions.

Audrey

 

[audreyh1]

Yes, M* includes dividend reinvestment.

I think expecting future returns to be somewhat less than past returns is prudent. This is for planning purposes after all. You want some cushion.

Audrey

 

[samclem]

According to Vanguard, historically a portfolio with my asset allocation returned 9.8% from 1926 to 2006... Now I know that past performance blah blah blah...

I think the "blah blah blah" part is something man of us wish away. I sound a bit like a broken record on this, but remember that the US was the only large economy that was up and running at the end of WW-II. We were geared up for production, and the world was primed with tremendous pent-up demand. The US economy exploded for 50+ years, with growth in stock prices, wages, standards of living, etc that were unprecedented in recorded history. That's the particular time window and geographic window you are looking at with that 9.8% figure. It's not gonna happen again. There are clear signs that this very unique period is over. Our economy is still the envy of the world, but the globalization of commerce means our goods and services are competing against some tough odds, and US stocks will simply no longer grow at the rate they formerly did in the face of this competition. That's one reason why many Americans are broadening their holdings beyond the US. It's not just an attempt to guess the next hot sector, it's a realization tha the US share of total world market cap has decreased.

My Magic 8 ball says 4% real growth for US equities over the next 40 years. I know that's not what you want to hear--me neither! But, if things turn out better than you'd planned, you'll get to FI even earlier.

 

[FIREd]

Audrey,

I know he was talking about a 3-3.5% REAL annual return. My point was that if you use a 4% annual "safe" widrawal rate then you will also have to withdraw 0.5-1% of your principal every year which does not sound "safe" to me. My mistake was to forget that the 4% SWR rule does assume dipping into the principal which is one aspect of the rule I am not very comfortable with. I would personnaly only use a 4% SWR if I was able to get a REAL average rate of return of 4% or more. If I can't get 4% REAL return, I would probably lower my SWR so that I won't have to dip into the principal. That's why I was saying that if real returns are 3-3.5%, then in my opinion a 4% SWR is not necessarily "safe".

But I agree whith most of you guys that it is better to use a conservative expected rate of return in the planning stage so that if there is any surprise down the road it is more likely to be a good one (reaching FIRE sooner), than a disappointing one. I Think I will use M* numbers for planning purposes from now on.

 

[FIREd]

My Magic 8 ball says 4% real growth for US equities over the next 40 years. I know that's not what you want to hear--me neither

Samclem, actually I could live with a 4% real return for US equities over the next 40 years. I will have to adjust my current savings rate to still be able to achieve my FI goal on time while taking into account lower expected annual returns.

 

[teejayevans]

Audrey,

I know he was talking about a 3-3.5% REAL annual return. My point was that if you use a 4% annual "safe" widrawal rate then you will also have to withdraw 0.5-1% of your principal every year which does not sound "safe" to me. My mistake was to forget that the 4% SWR rule does assume dipping into the principal which is one aspect of the rule I am not very comfortable with.

You sound fairly conservative, realize that there will be years that your
principal will go down on its own, possibly by double digits. If you can't
handle it, you might limit you investments in stocks and bonds, then you
are right, 4% will be too much.
TJ

 

[ESRBob]

SWRs of 4% don't necessarily have to involve eating into principal, although they do eat up some capital gains, which some people might consider the same thing (i.e. the withdrawal is not derived solely from dividends and interest, but also by spending some of the market appreciation).

The SWR method and Portfolios in Work Less Live More show how you can use a widely diversified, low-volatility portfolio (about half stocks, half bonds) to get not only a 4%-4.5% SWR, but also keep the value of the portfolio substantially intact, even in inflation-adjusted terms, over the long run.

 

[FIREd]

tee,

I am pretty conservative but I do not intend to get below a 50% stock allocation in retirement. I understand that some years my principal will go down because of the market. In those years, though, I plan on lowering my expenses (maybe cut them by as much as 25-30%) and take a lower withdrawal rate. My expected budget would be flexible enough to do that.

My plan is as follows: once I retire I will try to aim for a 4% average annual real return. Some years I may hit it on the nose and get 4% return. I would take the 4% and live on it. Some years I may get 6%. I would take the 6%, use 4% to live on and stash the other 2% in a MMA. If the next year I get only 2% real return, then I would take the 2% + the 2% that was placed in the MMA the previous year and live on that. I understand that some years the principal will go down. In those years I can hopefully take a lower widrawal rate and/or use excess money placed in the MMA from previous above average years.