Brent Sheather
Best to lower sights and tighten belts
The United States stock market has returned 6.5 per cent a year in real terms in the past 100 years. Since 1985 the real return was 7.9 per cent per annum. Last year the real return was almost 18 per cent.
Anyone fancy a guess as to the return of US shares in the next 35 years? No one knows for sure but one thing you can be confident of is that most of those wanting to invest your money will take an optimistic stance.
For example if you are a fund manager or financial adviser with high fees you will invariably forecast a high return so your fees look less extortionate. But if you are a non-compromised expert, working for a prestigious university in the US or Britain, you will more than likely have a realistic outlook and acknowledge the unfortunate fact that, all things being equal, the higher the stock market’s valuation, the lower the return will be in the future.
This is counter intuitive but if you think about it, it is quite easy to understand. Recall that stockmarket returns are a function of the dividend you receive and growth in profits.
Growth in profits in aggregate and in real terms has been reasonably steady over the long run so the key variable when you forecast long-term returns is the dividend you receive and the higher the stockmarket valuation is, the lower the dividend.
Back in 1979 the dividend yield on the US stockmarket was more than 5 per cent so one could be reasonably confident that long-term returns from that point would be higher than they will be today when the dividend, depending on how you measure it, is about 2.5 per cent.
That’s a bit complicated but luckily it is easier to estimate bond returns. Simplifying things somewhat, future bond returns are more or less equivalent to the yield you buy at.
Today the yield on 10-year US government bonds is 2.51 per cent whereas back in 1976 they were about 8 per cent. Given this perspective it’s pretty much certain that long-term returns from bonds and shares in the next 30 years will be less than they were in the past 30 years. So what have we got so far? Firstly that many of the people who forecast the future return on financial markets can’t be trusted to give an unbiased answer, and secondly that future returns are likely to be less than those in the past. At the risk of stating the obvious let’s look at why returns are important to KiwiSavers.
Future returns will determine how much you will need to save for your retirement. If your estimation is too high you risk not being able to afford that world cruise when you hit 65. In addition a realistic guesstimate of how much you will earn allows you to put the cost of earning that return into perspective — a 1 per cent fee looks reasonable if your return after fees and tax is 8 per cent but costly if you can only expect 3 per cent after fees and tax.
Forecast returns are critical, so much so that the FCA, the equivalent of the FMA in England, has seen fit to determine what forecast of future returns financial advisers and fund managers can use.
Given the continued abuse of forecast returns locally, one hopes the FMA will follow the FCA’s lead. As this column discussed a few weeks back the finance industry is often the author of “fake news” but the facts are there if you know where to look.
There are some independent and skilled investment experts left who are able to embrace an appropriate long-term perspective, have a sense of history and an unbiased methodology so as to intelligently speculate as to the fortunes of a longterm savings plan. Just recently several experts have updated their view on the returns of balanced portfolios in the long run. An article in the Journal of Finance by three experts at AQR Capital Management wrote a paper, How Much Should Defined Contribution Savers Worry About Expected Returns, giving useful insights into not just future returns but how low returns might relate to savings needs. The PhDs from AQR estimate that global equities and global bonds will return 5 per cent a year and 1 per cent a year respectively in real terms over the long term. The authors make the point that “anchoring too much on historical results may paint a picture that is far too rosy. Past market returns were high partly because starting yields for both stocks and bonds were higher — in other words the assets were cheaper than they are today. Moreover stocks and bonds became more expensive thanks to falling yields and rising valuation multiples giving windfall gains to investors”. Significantly AQR estimates a 1 per cent fall in expected returns from 5.5 per cent to 4.5 per cent requires 3 per cent more in extra savings over the long term to meet a long-term savings objective. The other interesting forecast of long-term returns came from US consulting group McKinsey & Company which published a paper entitled Look out below: Why returns are headed lower.
McKinsey reckons that in a continued slow-growth world economy long-term returns for US stocks will be around 4.5 per cent a year in real terms improving to 6.0 per cent real if we have a recovery in growth.
For US government bonds they reckon long-term returns will be 0.5 per cent real in a slow growth scenario and 1.5 per cent a year with higher growth. If we add to the average of those figures 2.0 per cent inflation we get nominal returns of around 7.0 per cent for shares and 3.0 per cent for bonds.
What is particularly interesting about the McKinsey analysis is that they have decomposed the historic returns from US bonds and US shares over the 1985 — 2014 period to show the extent to which they were assisted by non-recurring factors, i.e. markets getting more expensive.
Looking at bonds first McKinsey shows that the real return from US bonds benefited from 1.8 per cent a year in capital gains due to falling real interest rates and 1.3 per cent a year in gains due to lower inflation.
In respect of US shares in the same period returns benefited from a 1.3 per cent per annum rise in valuation and a 1.1 per cent increase due to higher profit margins so that the total real return from shares in that period was 8.9 per cent, well ahead of the 6.5 per cent a year real return from 1915 -2014.
McKinsey goes on to warn that individuals saving for retirement should “lower their sights and tighten their belts”.
Brent Sheather is an authorised financial adviser. A disclosure statement is available upon request. Brent Sheather may have an interest in the companies discussed.