Swedroe: 4 Horsemen Of Your Portfolio

February 07, 2018

A common axiom is that those who fail to plan, plan to fail. And while most people would never start a business without a business plan, many investors manage their money without an investment plan that identifies their ability, willingness and need to take risk, sets goals (such as the rate of return they require their portfolio to generate), and includes an asset allocation and rebalancing table to provide discipline.

Compounding the problem of a failure to plan is that even a well-thought-out investment plan is only a necessary condition for success, not a sufficient one. Even the “perfect” investment plan can fail for reasons that have nothing to do with its investment results.

Examples of how plans can fail for noninvestment reasons include the premature death of a family’s main income earner combined with insufficient life insurance, forced early retirement, the lack of sufficient personal liability insurance (such as an umbrella policy), poor estate planning (such as neglecting to keep beneficiary designations updated), the lack of appropriate medical insurance (such as long-term care coverage) and even living longer than expected.

This is why the right approach is to create a fully integrated estate, tax and risk management plan.

These issues have always existed. However, today’s investors, whether they’re planning for retirement or already in the withdrawal phase, face four hurdles that their predecessors didn’t. If these hurdles aren’t planned for, the odds of ending up without sufficient assets to maintain a desired—let alone a minimally acceptable—standard of living can greatly increase.

In Biblical tradition, the Four Horsemen of the Apocalypse are a quartet of immensely powerful entities personifying the four prime concepts—war, famine, pestilence and death—that drive the Apocalypse.

For today’s investors, the equivalent of those four horsemen are historically high equity valuations, historically low bond yields, increasing longevity and, as a result, the increasing need for what can be very expensive long-term care.

1. Historically High Equity Valuations

From 1926 through 2017, the S&P 500 returned about 10.2%. Unfortunately, many investors naively extrapolate historical returns when estimating future returns. In this case, that’s a bad mistake, because some of the return to stocks was a result of a declining equity risk premium, resulting in higher valuations. Those higher valuations now forecast lower future returns.

The best metric we have for estimating future returns is the Shiller cyclically adjusted price-to-earnings (CAPE) 10 ratio. The inverse of that metric is an earnings yield (E/P). It is used to forecast real returns. As I write this, the Shiller CAPE 10 is at 34.3, producing a forecasted real return of just 2.9%. To get an estimate of nominal returns, we add the difference between the yield on the 10-year nominal Treasury bond (2.63%) and 10-year TIPS (0.57%), which is about 2%. That gives us an expected, forward-looking nominal return to stocks of roughly just 5%, or about half the historical level.

Before moving on to look at bonds, I will note that forward-looking return expectations for international stocks are better, though, again, well below historical returns. The Shiller CAPE 10 earnings yield for non-U.S. developed markets and emerging markets at year-end 2017 were 5.1% and 6.3%, respectively.

Again, if forecasting nominal returns, you should add about 2% for expected inflation. Thus, if you have an allocation to international markets, your forecast for returns should be somewhat higher than for a U.S.-only portfolio.

Unfortunately, the story on the bond side is not any better.


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