Swedroe: Toss Your Expectations

June 27, 2018

It’s impossible to prudently build an investment plan without estimating the return to stocks (and bonds), making such estimates a central component of the process. This estimate will determine your need to take risk—how high an allocation to equities you will need to reach your goal.

If your estimate is too high, it’s likely you won’t have sufficient assets to reach your retirement goal. If it’s too low, it could lead you to allocate more to equities, which means taking more risk than necessary. Alternatively, it could lead you to lower your goal, save more, or plan on working longer.

Despite its importance, there is much disagreement about how to estimate stock returns. As is always the case, at Buckingham Strategic Wealth, we rely on academic evidence.

Recent Research

Research on the expected equity premium, including Aswath Damodaran’s 2017 paper, “Equity Risk Premiums (ERP): Determinants, Estimation and Implications,” has found that the best predictor of future equity returns is current valuations—whether using measures such as the earnings yield (E/P) derived from the Shiller CAPE 10 (or, for that matter, the CAPE 7, 8 or 9) or the current E/P—not historical returns.

A review of the evidence led Damodaran to conclude: “Equity risk premiums can change quickly and by large amounts even in mature equity markets. Consequently, I have forsaken my practice of staying with a fixed equity risk premium for mature markets, and I now vary it year to year, and even on an intra-year basis, if conditions warrant.”

Damodaran’s approach is similar to the one we use at Buckingham Strategic Wealth. At the beginning of each year, we estimate returns for all asset classes and then use those estimates in our assumptions when running Monte Carlo simulations. For equities, while our methodology has changed somewhat over time, our forecast always has been based on current valuations, not historical returns.

Today, we take the average of the estimate using the Shiller CAPE 10 E/P and the Gordon Constant Growth Dividend Discount Model. For factors other than market beta (such as size and value), we have chosen to give the historical premium a 25% haircut—based on research showing some degradation of premiums, even risk-based ones, occurs post-publication. That, in turn, helps us determine the most appropriate asset allocation for clients.

We have been following this process since 2003. I thought it would be an interesting exercise to evaluate the accuracy of our forecasts. Before digging into the results, it’s important to understand that investors should treat all estimates of returns to risky assets only as the mean of what is potentially a wide dispersion of returns.

In other words, it’s unlikely you will earn the mean, estimated return. That is why we use Monte Carlo simulations to help us determine the most appropriate asset allocations—expected returns are not deterministic, but probabilistic. For example, let’s consider the results from Cliff Asness’ study on the Shiller CAPE 10’s ability to forecast future returns.

Shiller CAPE 10: Good Indicator

In a November 2012 paper, “An Old Friend: The Stock Market’s Shiller P/E,” Asness, of AQR, found that the Shiller CAPE 10 does provide valuable information. Specifically, he found 10-year-forward average real returns drop nearly monotonically as starting Shiller P/Es increase.

He also found that, as the starting Shiller CAPE 10 ratio increased, worst cases became worse and best cases became weaker. Additionally, he found that while the metric provided valuable insights, there were still very wide dispersions of returns. For instance:

  • When the CAPE 10 was below 9.6, 10-year-forward real returns averaged 10.3%. In relative terms, that is more than 50% above the historical average of 6.8% (9.8% nominal return less 3.0% inflation). The best 10-year-forward real return was 17.5%. The worst 10-year-forward real return was still a pretty good 4.8%, just 2.0 percentage points below the average and 29% below it in relative terms. The range between the best and worst outcomes was a 12.7 percentage point difference in real returns.
  • When the CAPE 10 was between 15.7 and 17.3 (about its long-term average of 16.5), the 10-year-forward real return averaged 5.6%. The best and worst 10-year-forward real returns were 15.1% and 2.3%, respectively. The range between the best and worst outcomes was a 12.8 percentage point difference in real returns.
  • When the CAPE 10 was between 21.1 and 25.1, the 10-year-forward real return averaged just 0.9%. The best 10-year-forward real return was still 8.3%, above the historical average of 6.8%. However, the worst 10-year-forward real return was now -4.4%. The range between the best and worst outcomes was a difference of 12.7 percentage points in real terms.
  • When the CAPE 10 was above 25.1, the real return over the following 10 years averaged just 0.5%—virtually the same as the long-term real return on the risk-free benchmark, one-month Treasury bills. The best 10-year-forward real return was 6.3%, just 0.5 percentage points below the historical average. But the worst 10-year-forward real return was now -6.1%. The range between the best and worst outcomes was a difference of 12.4 percentage points in real terms.

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