Previously, we examined three main factors conspiring against investors seeking higher expected returns. These factors can combine to generate a “perfect storm,” at least from an investment perspective, facing today’s investors. We then turned to the four most effective ways that investors can fight these head winds, which, oddly enough, have nothing to do with investing. We’ll now cover some additional investing-related steps you can take to help ensure you don’t run out of money in retirement.
Increase Your Equity Allocation
While today’s higher valuations do forecast lower future returns, this doesn’t necessarily mean stocks are overvalued, just more highly valued than historically has been the case. I’ve explained previously why higher valuations aren’t signaling overvaluation, as many gurus have been stating. And while higher valuations do forecast lower returns going forward, there’s still a relatively large equity risk premium.
The S&P 500 has an expected return a full 4.5 percentage points higher than the five-year Treasury (specifically, the difference between a 4.2% expected return and a -0.3% expected return). While lower than the historical premium, that’s certainly not economically insignificant.
However, raising the equity allocation in your portfolio does entail taking on significantly more risk, which you should consider only if you truly have the ability, willingness and need to do so. Especially with stocks, the higher expected return is called a risk premium for good reason. Thus, while it’s an option worth contemplating, it wouldn’t necessarily be my first choice.
Increase Your Allocation To International Stocks
Unfortunately, most investors have a significant home-country bias. They believe that the stocks of their home country are not only safer, but have higher expected returns (an illogical conclusion). As a result, investors tend to dramatically overweight their equity investments in their home country relative to the way the world allocates capital.
This phenomenon isn’t just found in the United States; it’s a global occurrence. Today U.S. equities make up only about 50% of the world’s total market capitalization for stocks. Thus, a logical starting point for thinking about this issue is to have half of your equity allocation in international stocks. Yet the typical investor allocates only a small fraction of that amount outside their borders.
Now, there are some good reasons to have a small home country bias. The first is that investing in U.S. stocks generally can be a bit cheaper. For instance, expense ratios of domestic mutual funds and ETFs tend to be lower. The second is that U.S. stocks can be a bit more tax efficient, especially in tax-advantaged accounts, because of issues related to foreign tax credits.
On the other hand, if you’re in the workforce, it’s highly likely that your labor capital (which, for younger workers, can be their largest asset) is highly correlated with domestic economic and geopolitical risks. That should lead to a bias to allocate more to international assets.
How would increasing the allocation to international stocks impact expected returns today? The CAPE 10 for non-U.S. developed nations is currently about 15. That produces an earnings yield of 6.7%. Making the adjustment for the five-year lag produces an expected real return of 7.4%, or 3.2 percentage points more than for U.S. stocks.