Market Return

[Jane]

Everytime I use some financial calculators, they always ask me to enter estimated future return. And everytime, my knee-jerk reaction is always a frustrated "How do I know?!". Of course my second reaction is to enter 4-6% after inflation. That usually gets me thinking of the conventional wisdom of "8-10% market return" (before inflation).

My question is: where did this number come from and how did it get justified to estimate future return of equity investment?

I read many times about some studies that showed that the return of equities from 1800 - present was a consistent 8-10% before inflation. And from these studies, people in finance/financial media concluded that 8-10% is "reasonable" to predict future return on investment.

The trouble is for me, I think this kind of thinking is flawed.

First, I wonder how the "studies" got their numbers? Survivor bias is mentioned many times. To me, "survivor bias" means we should realize that we are talking about a specific case study and thus instead of concluding 8-10% return in general, we should conclude "if we invest in winning companies and hold this investment for decade(s) then history shows that we may get 8-10% return". But how easy it is to always buy winning companies/funds and hold them for decades? Choosing/holding such companies/funds is only easy in retrospect.

Second, these "studies" surveyed mostly US companies in US market. This "8-10% return" resulted during a period which US grew from a new nation to world's economical superpower. Again, that is a very specific time in history which makes this a "special case study". Will US grow from superpower to superpower^3 and will it affect the market return similarly? Should we invest in countries poised to be the next superpower to duplicate historical studies? (And which country anyway?)

Third, history can and has at times, repeated itself in similar circumstances. So is the market today is similar with the markets of the past? Is the economy today similar with the economy of the past? If they are 2 different circumstances then how can we conclude that history will repeat itself? When did history decide then it owes us 8-10% return when we can't produce a similar circumstance where it can repeat itself?

Can anyone put me at ease and show me (or point some books for me) that this magic number can be used reasonably to estimate future return? At work, if I say "We will have X flow since the pump will produce y pumping capacity", my boss will then ask me "How do you know the pump has y capacity?". I will certainly get in trouble if I say, "Well operators said that in the past 10 years the pump has been producing y". That answer would not be acceptable. My boss can say, "well, it could be a different pump, pump could be old etc. Find out what pump they intend to use and what exactly its capacity". Ok, it's long-winded but my point is that we do not use historical data in our work to estimate future production, we use present data that we know will still be applicable in the future (ie. you don't replace pump every year). I am having trouble at the thoughts that I am using "historical" data in my financial planning.

My naive concern is that you can't predict future return/or it's more of "vodoo magic" than exact science.

What do you think?

Jane

[Bob_Smith]

Jane, read this:

http://www.vanguard.com/bogle_site/sp20030605.html

[Hyperborea]

First, I wonder how the "studies" got their numbers? Survivor bias is mentioned many times.

Survivor bias can be discounted on things like S&P500 which takes us back to 1927 (and back to 1880 IIRC from the Cowles commission numbers). The reason for this is that usually before a company would implode it would fall from the S&P500. If it imploded while on the S&P500 the results are included. So, if you are investing in say an S&P500 index fund you can rely on that historical number as historically valid.

Second, these "studies" surveyed mostly US companies in US market. This "8-10% return" resulted during a period which US grew from a new nation to world's economical superpower. Again, that is a very specific time in history which makes this a "special case study". Will US grow from superpower to superpower^3 and will it affect the market return similarly?

Shhhh! You keep bringing up the pink elephant in the corner and the Americans will get upset. I've mentioned this a number of times here and on other sites (TMF for example) and the Americans regularly dismiss this because nothing will happen to stop the US from remaining the world superpower. The same thing that happened to every other country won't happen to them.

Personally, I would think that it is prudent to diversify across the world market. I've been doing this with my investments pretty much since I seriously started investing. You might want to look at this paper for a discussion of international return data - http://www.gsm.uci.edu/~jorion/papers/century.pdf

Should we invest in countries poised to be the next superpower to duplicate historical studies? (And which country anyway?)

The best advice that I've seen here is to invest in a world market portfolio and you will capture most of the return as if you had "magically" guessed the correct answer to who will have the best returns.

My naive concern is that you can't predict future return/or it's more of "vodoo magic" than exact science.

What do you think?

There is definitely a large amount of "voodoo" to it. The best that we can do it seems is to diversify, use what correlations have the most evidence and some reasonable logic behind them (to differentiate them as much from the random correlations), have some fallbacks (be able to work longer if returns aren't up to snuff, skills to return to working if FIRE fails, etc.), and hope for the best.

[haha]

My naive concern is that you can't predict future return/or it's more of "vodoo magic" than exact science.
What do you think?
Jane

Jane, speaking only for myself, I think you are not naive, you are right to question these numbers. You have pointed to the undeniable fact that the Emporer is naked.

The way of the world seems to be that things go along most of the time without discontinuous change.

Then suddenly that is no longer true.

My personal response to this given current valuations is to stay light in equities, and of the equities I do own to prefer yield and likely stability over other considerations. Also I keep fixed income very short duration and with little or no credit risk.

I also have overweighted energy at 17%, and gold equities at 7%. Don't know for sure whether this is a good plan or not. So far the energy has been spectacular, the gold well above cost of capital but perhaps not yet an adequate return considering risk. I also plan to invest between 1 and 1.5% per year in index put options.

I guess it seems to me that our assumptions are so important, that fine tuning with calculators etc. could be deceptive. Except when they show that something clearly won't work.

Mikey

[ESRBob]

Jane, read this:

http://www.vanguard.com/bogle_site/sp20030605.html

Bob,
Nice link,
thanks for this. Didn't know about this Bogle research info inside the vanguard site...

ESRBob

[unclemick]

One of my favorites among many Bogle articles.

[Bob_Smith]

Bob,
Nice link,
thanks for this. *Didn't know about this Bogle research info inside the vanguard site...

ESRBob

ESRBob and unclemick, I re-read that periodically. It helps me refocus.

[Nords]

My question is: where did this number come from and how did it get justified to estimate future return of equity investment?

The trouble is for me, I think this kind of thinking is flawed.

Yup, you're right. Past results still aren't good guarantees of future performance, whether they pass the survivor bias test or not.

When you come up with a better method, let me know!

My naive concern is that you can't predict future return/or it's more of "voodoo magic" than exact science.

What do you think?

Jane

Even if you can make some sort of macro prediction, chaos is still working against you. For a still gloomier summary of your disturbing thoughts, try Bernstein's "Retirement Calculator from Hell" series!

http://www.efficientfrontier.com/ef/998/hell.htm
http://www.efficientfrontier.com/ef/101/hell101.htm
http://www.efficientfrontier.com/ef/901/hell3.htm
http://www.efficientfrontier.com/ef/103/hell4.htm
http://www.efficientfrontier.com/ef/403/hell5.htm

Unless you elect to live in Ted Kaczynski's old place and eat MREs for the rest of your life, then projecting old data is as good as it gets. Subtract a "safety factor" from your returns (right, "How the @#$% do I know what safety factor to use?!?) depending on your degree of paranoia/pessimism.

Or try a library copy of Bud Hebeler's planning book on his iterative closed-loop negative feedback approach: http://www.analyzenow.com/retirement_plan_book.htm.

Hey Nords, good post! I was thinking of moving to
Ted Kaczinski's "old place" but the authorities
disassembled it so that is no longer an option. Bummer!

John Galt

[Jane]

Thanks for all the links I will check them out (slowly though - here in Canada it's not Thanksgiving holiday).

As Nords said, it's a disturbing thought but in principal I think that it is the most important concept to grasp in investing. What's more disturbing is that many investors based their picks on "historical performance" without understanding that: history *does not* owe us anything!

It's distrubing that 3 financial advisors I interviewed few years back mouthed off the "historical number" as if it was equivalent to say, Gravity. Maybe it was why I decided against FA altogether.

Like Hyper I diversified (as best as I could). I hold index funds for Canada, US and International. I still have some no-load mutual funds in my pension plan because I don't have access to index funds there. And I am crossing my fingers hoping for the best.

Jane

[ats5g]

Hey Jane,

And the next time someone tries to tell you that stocks are "safe long term investments", show them this Jorion paper :

The Long-Term Risks of Global Stock Markets

- Alec

[ats5g]

opps, hit post too soon. :P

This Journal of Financial Planning article maps out how people arrive at these numbers, and what may be logical/reasonable given the current prices of stocks:

What Do Past Stock Market Returns Tell Us About the Future?

It's also thought provoking to consider the question, "Did any investor actually get these historical rates of return?" Given the lack of tax efficient market index funds, heavy loads and expenses, I would highly doubt it.

- Alec

[hocus]

"My naive concern is that you can't predict future return/or it's more of "vodoo magic" than exact science."

You brought some good questions to the table, Jane. This is an important thread, in my view.

That said, I agree with the point made by Nords. If an aspiring early retiree is not enthused with the idea of using historical data to get a fix on how her income streams are likely to hold up over the long run, what the heck is she going to use instead? You need a number to plug into your plan. At some point, your vague thoughts about how your investments might perform must be translated into a number. Making use of historical data permits you to translate the words that your vauge thoughts are made up of into the numbers you need to put a plan down on paper.

It makes sense to use calculations performed by others to come up with starting-point numbers. But it is critical to understand the assumptions in which those calculations are rooted and to perform your own assessment as to whether the numbers that result from the calculations make real-world sense. If not, you need to make adjustments to them before incorporating them into your plan.

Developing a deep understanding of the assumptions behind the numbers you use is critical. Accepting numbers when you don't fully grasp the assumptions on which they are based is dangerous. It is probably better to make use of no numbers at all than to do that. There's an old saying that "It's not the things you don't know that really hurt you, it's the things you know for certain that just ain't so." When you accept a number without understanding the assumptions on which it is based, you run the risk of coming to know for certain something that ain't so.

[Roger_R]

If an aspiring early retiree is not enthused with the idea of using historical data to get a fix on how her income streams are likely to hold up over the long run, what the heck is she going to use instead?

I afraid I am a bit of contrarian in my own thoughts on this. I'm not entirely negative about using historical data, but take it with a larger grain of salt than many. If you want an idea of how long your income stream is going to last, without using historical data, you could include in your considerations your total savings, divided by your remain life expectancy. Consider a total in vestment in inflation protected securities and add a small bonus for real rate of return.

[Bob_Smith]

If you want an idea of how long your income stream is going to last, without using historical data, you could include in your considerations your total savings, divided by your remain life expectancy.

Roger, I'm not sure I follow how that formula would tell you how long your income will last. If you divide savings by life expectancy, wouldn't the result provide a rough idea of what you can spend? In other words, a 40 year lifespan would always produce a 2.5% withdrawal rate, right? Or am I missing something?

[Roger_R]

If you divide savings by life expectancy, wouldn't the result provide a rough idea of what you can spend? In other words, a 40 year lifespan would always produce a 2.5% withdrawal rate, right? Or am I missing something?

Yes. *That's a simple approach without using historic returns. *Throw in a real rate of return of one or two percent if you'd like. *I realize that this tends to over simplify and relies on the fact that you are entirely invested in inflation protected securities. *

If you are thinking perhaps that I am somewhat out of my gourd, it is a little similar to a method mentioned by the Coffee House invester in one of their "portfolio ponderings" articles a few weeks ago. *Not to say they may be a bit daft, too .

[unclemick]

And then there is 'old school' - take the market return of 'your portfolio' - div/interest and let the principle ride. That's about 3% for us nowadays.

[Hyperborea]

If you want an idea of how long your income stream is going to last, without using historical data, you could include in your considerations your total savings, divided by your remain life expectancy. *Consider a total in vestment in inflation protected securities and add a small bonus for real rate of return.

So, you're suggesting that somebody retiring at 40 with maybe an estimate of 60 years of life left who wants a $40K / year income needs to have $2.4 Million? Should they deposit this all at their local bank? Or buy gold coins and bury them in mason jars in the back yard?

[Roger_R]

The original issue was if there was a method to calculate income stream without historic returns or if you have little faith in them. That is what I presented.

Obviously if you put your savings in the bank or buried it in your back yard inflation would eat you alive if you had 60 years of retirement.