By Gary Brooks, CFP®
As we turn the calendar to a new year, many investment management and market research companies forecast future returns for various types of investments.
These forecasts all use sophisticated techniques often combining economic conditions, stock and bond market data, interest rates and even investor sentiment to project future performance.
It is interesting to read the rationale behind each forecast, but the only thing we know for sure is that they are all wrong.
I trust that the analysts and researchers generating forecasts are using credible methodology. But a complex system of global markets, responding to constantly changing influences, is unlikely to arrive at an outcome anywhere near even the most robust financial modeling.
And yet, what are you to do when this is the information that you must work with for investment decisions and retirement planning? At best it will be inaccurate. At worst, not even in the ballpark.
Whatever degree of wrong it may be does not mean it is worthless, however. When doing any form of long-term projections of asset growth compared to your expected spending, you need to have an assumed rate of return on your assets over time.
Calibrating the crystal ball
Not to single out which forecast I believe is the most legitimate, I’ll reference some data from Vanguard simply because it is a well-known company and manages approximately $4 trillion dollars.
Vanguard’s Capital Markets Model projects a range of returns over 10 years for different investment asset classes. Vanguard has a lot of company with the viewpoint that investors should prepare for lower returns than stock or bond markets have delivered over the past generation. Knowing that no single forecasted number will be correct, Vanguard presents ranges of possible outcomes: 25% probability, 50% probability, 75% probability, and so forth.
I track a model portfolio that is a globally balanced mix of 60% stocks, 40% bonds and other assets. If I were building a portfolio from cash in a single account for an investor that wasn’t particularly aggressive or conservative, it would look like this.
When applying Vanguard’s forecasted returns for the next 10 years to this model portfolio, the Vanguard Capital Markets Model suggests there is:
- a 25% likelihood that the portfolio could return 8.4% on an average annual basis over 10 years.
- a 50% likelihood that it would return 5.2% or better.
- a 75% likelihood of at least a 1.9% average annual return.
The outcome of a financial plan using 5.2% as the expected return will have a drastically different rate of success than an 8.4% or 1.9% expected return.
Even differing forecasts have some value, because they provide a framework for decision making. In terms of investments, the forecasts help inform how to weight stocks vs. bonds and alternative investments in a diversified portfolio. They can help identify the difference between risk and opportunity. In the case of the Vanguard forecast, it demonstrates that bonds have significant risk of not keeping up with inflation because of low interest rates. This may cause income-oriented investors to think differently about their investments than they have over the past couple decades.
Whether it’s over five, 10 or 20 years, factors that influence forecasts will change many times. More valuable than the forecasted numbers is preparation for a future that is certain to be uncertain.
Process vs luck
Given the high level of uncertainty, it becomes very important to have an investment process. Even if the process is only generally correct, as long as it is not precisely wrong, the investment outcome should represent progress towards goals. Too many investors, applying hope as a strategy rather than trusting a well-conceived process, are reliant on luck.
“An investor with a solid process may be unlucky in the short term but ultimately more successful over time,” Michael Mauboussin wrote in his book The Success Equation.
The value of a process is that it allows people to overcome human nature — the buy-high, sell-low condition of people responding to markets beyond their control. Occasionally, bad behavior is rewarded and a bad habit forms, causing people to believe they have more control over the short-term outcome than they do.
The only control you have over investment performance comes from the discipline you apply to your buying and selling process. Regardless, many people forget the process and respond only to the outcome, ignoring that, over time, the process will be more influential than luck on overall investment returns.
There is no single correct investment process. There are, however, hallmarks of a process that has a higher probability of success: diversify globally, rebalance periodically and be mindful of expenses (e.g., taxes, transactions and management fees).
With these tenets of smart investing as your foundation, you can make modest adjustments based on forecasts to respond to growing risks or opportunities. Market prices will dislocate from reasonable justification from time to time, both in your favor with exceptional returns and out of your favor with negative returns. We know this will happen, and it won’t be signaled in any forecast.
This is an updated version of my monthly personal finance column that was published in the Tacoma News Tribune in October 2013.
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