Now We Know What the Future Holds! by Nate EadsSubmitted by Moller Financial Services on May 27th, 2016
“I’ll be working until the day I die”. Could this be Carnac the Magnificent’s answer to the question of “Will investors ever have enough money to retire?”
(If you don’t remember or are too young, Johnny Carson played a recurring character, Carnac the Magnificent, that would predict the answer to questions provided in a hermetically sealed envelope). It likely would be if he just read the report recently released by the McKinsey Global Institute on the future of stock market returns. In case you missed it, a few weeks ago The McKinsey Global Institute released a report that garnered plenty of attention. The crux of the report is that they are predicting equity returns over the next several decades to be “considerably lower” than they have been over the last three decades.
One of the most effective ways to get noticed in financial writing is to first elicit fear in your readers and then to tell them what bad thing(s) will happen in the future. Several of the media outlets that picked up this report went further on the fear scale by adding in their own headlines. Take Bloomberg for example. Their article summarizing McKinsey’s report was titled “End of Golden Era for Investors Spells Troubles for Millennials”. Even better is the verbiage used in the link to Bloomberg’s article shown below in bold.
Of course the beauty of making such bold predictions for the next several decades is that if you are wrong, nobody will remember you made them. No one knows the answer to what returns will be over the next several decades or how the economy will grow or shrink during this time. It is arrogant for anyone to say with any certainty that they do.
Sequence of returns matter
Financial blogger Ben Carlson pointed out that even if the prediction of lower returns is correct, the sequence in which they occur is actually more important.
Let’s look at two examples from Ben to see why this is the case.
Scenario #1: A person starts saving $5,500/year and increases that amount by 4% each year to account for inflation and salary increases. They save for 30 years and earn a steady 6.5% each and every year. After 30 years they would end up with roughly $743,000.
Scenario #2: A person starts saving the same $5,500/year and increases that amount by 4% each year to account for inflation and raises. They save for 30 years as well, but instead of earning a steady 6.5%/year they earn just 3.2%/year, with alternating annual returns of +12% and -5%, for the first 20 years. Then they earn 13.5%/year in the final 10 years. This still works out to an annual average return of 6.5% just like in the first scenario, but because these returns were so poor in the early stages of saving and higher in the latter stages, this person’s ending balance was closer to $1,000,000.
Both scenarios saw the exact same amount saved over the exact same time frame and earned the exact same annual returns. But the sequence of those returns caused a huge difference in their ending balances. The second scenario was more than 30% higher than the first one.
Could we already be most of the way through the “decades of considerably lower returns?”
Like most articles that use historical data to make their point, a bit of data mining is often involved (just like I’m about to do!). Since 1926 the S&P 500 had a compound rate of return of 10% over those 90 years. Over the last 30 years, the time frame used in the McKinsey article, the S&P 500 had a return of 10.4%, so higher than average. This “high return”, along with several other factors they predict will happen, are the basis for their forecast of lower returns for the decades ahead. Who’s to say our “decades of considerably lower returns” didn’t already begin back in 2000? The S&P 500’s annual return since 2000 has been just 4.1%. The worst 30 year rolling return in history occurred at the height of the market just before the Great Depression, included World War II, the Korean War, and four recessions, and stocks still returned almost 8% per year during that time. So let’s assume the 30 year period beginning in 2000 is similar to the worst 30 years in market history. The first 15 years have given us a return of just 4.1%. In order to attain just an 8% return over the full 30 years the market would need to have about a 12% annual return over the next 15 years!
The point here is not to predict that returns are going to be higher than average over the next 15 years (although if they are, please remember I told you so), but rather when historical data is used to make a prediction of future results, you can usually find data to support your argument no matter which side you’re on.
Investing in companies, not economic measurements
Often investors get caught up in broad economic data when trying to forecast stock market returns. Which way is inflation headed? What was the last quarter’s GDP? While these macro factors have an impact on our economy, they are not the deciding factor if a company is profitable or not. Remember, investing in stocks is becoming an owner of companies, companies whose profits and growth may be very different than the economy around them. Also, who knows which companies will be responsible for the market return over the next several decades? For example, compare the top ten holdings of the S&P 500 in 1986 to 2016.
|Shell||Johnson and Johnson|
Half of the companies that now make up the S&P 500 top ten were barely or not in existence 30 years ago. Who foresaw a social networking site started in a college dorm becoming one of the world’s ten most valuable companies? Over the next several decades there will surely be companies that are very profitable and those who own stock in them will benefit.
When it comes to predicting what will happen in the economy and markets over the next several decades, I wouldn’t put any more faith in the “experts” than I would in Carnac the Magnificent. What I do know is we manage our clients’ portfolios in the context of an overall financial plan, not based on making market predictions. By continually monitoring and updating their financial plans we will make adjustments as needed to be in the best position to achieve their goals.