Investment questions can be as diverse as the individuals who ask them, but one question that we hear consistently from the families that we serve is: What rate of return should I expect going forward? This question usually has two components. The first is related to what we expect for the near-term 1 – 3 year environment. The second is related to what rate of return might be accomplished over a longer window of time. In this Investment Perspectives we will discuss how we approach answering this question as well as why the answer to it may not matter as much as one might think.
Forecasting is difficult… no, it is impossible
The honest answer to the 1 – 3 year forecasting part of the investment return question is that we have no idea what returns will be over such a short time period. Forecasting the future is an inherently difficult task, especially when dealing with complex systems. (Just ask your local weatherperson.) The global economy and its many individual financial markets contain too many variables to even count. Consequently, financial forecasters are not very successful. In fact, they are inaccurate 93% of the time in making relatively shortterm 2-year forecasts. Longer term forecasts are even less accurate, since the range of potential outcomes increases with the length of the forecast period and forecasting errors tend to compound over time. Moreover, the few forecasters who achieve accuracy in one time period, seldom repeat this accuracy in following time periods. Put simply, a perfectly accurate forecast is largely a product of good luck rather than skill.
Consider the embedded table, which compares J.P. Morgan’s 2009 long-term 10—15 year forecast to what has actually materialized in the past 10 years.
This forecast was prepared by a major investment firm that employs a highly educated team which is certainly well qualified. The predictions were accompanied by a believable and coherent narrative that logically explained why such results would ensue. And yet, they appear to be quite incorrect. While the final analysis on this forecast cannot be completed for a few more years, it is widely off the mark so far. How can this be? Unsurprisingly, it turns out that incredibly smart people are still unable to see the future. It can also be difficult to maintain objectivity in moments of extreme optimism or pessimism. After all, such strategists are not immune from the emotions that make us human as well as environmental influences or experiences that shape their perception of reality. The intent here is not to call out J.P. Morgan for being wrong, but rather to observe that even vast resources and credentialed staff don’t guarantee a successful forecast. Experts may sound incredibly confident, but that doesn’t mean that they will be right.
With such dismal odds, why does anyone even try to forecast? Because people want them to. People like to feel in control of their financial situation, and when the future feels uncertain and unsettling, they look to socalled experts to help them make order from perceived chaos. When a forecast is delivered with conviction and a strong sense of expertise, it can serve the purpose of providing peace of mind, even if it is likely to be dead wrong. With such blatant inaccuracy, how can this practice continue? In reality, not too many people go back to verify whether a forecast ever turned out to be accurate, so forecasters generally do not have a high degree of accountability to their inaccuracy. They simply continue to make forward-looking guesses, which helps to build their reputation as experts. And this reputation can often serve to accomplish their business goals, which is usually to sell a specific brand of products. (Most analysts are employed by major investment firms who sell products to investment consumers.)
Paracle’s Approach to Forecasting
Paracle is not in the business of selling investment products. Rather, we are in the business of building trusted relationships that may last for multiple generations. With this in mind, we have a high incentive to tell the families we serve the truth rather than making up stories that may sound intelligent, but that are very likely to be inaccurate. Our clients are often disappointed when we tell them that we don’t have a clear picture for how investment markets will perform over the coming years, that the only things we can ever say with certainty are that we expect markets to rise over long periods of time, and that it is likely to be a roller coaster along the way. While this may sound inconclusive and possibly even discouraging, we are merely setting a proper foundation for a meaningful conversation that offers much better news. Namely, with proper planning, having a perfect investment forecast doesn’t matter. By planning for a wide range of potential investment outcomes, we can help establish the sense of confidence that people desired when they asked the question in the first place. We cannot see the future, but we can observe the past. While history never repeats itself exactly, studying historical patterns and relationships proves to be a very good guide for setting forward expectations. We use very long-term historical data in our assumptions for planning, going back to the mid 1920’s. This long history captures the ups and downs of a variety of economic environments, including wars, depressions, political uncertainties, and the rise and fall of individual nations. We use these historical patterns as inputs into a forward-looking simulation. Specific client goals are the certainties that we want to accomplish, and we are able to stress test these goals using thousands of life-like simulations to determine if all of the goals can be accomplished with a high certainty level in a wide variety of market environments.
The question of long-term return expectations seems on its face like a much easier one to answer. With nearly 100 years of history as a guide, we can certainly identify a long-term average rate of historical return for any given portfolio structure. However, the returns that are accomplished over a specific individual’s investment time horizon can still be quite different than the returns that were accomplished over the longest data set. It may surprise you to know that it is quite rare to actually earn the average long term return over a given time period. Additionally, many 10- year time periods (and even longer ones) actually fall below the long-term averages.
In fact, many families we serve have experienced such a time period, as returns since the early and mid-2000s have been running below average. Is this alarming? Not really. One very important thing to keep in mind is that returns for both stocks and bonds are highly correlated with the rate of inflation. More often than not, lower investment returns have accompanied below average inflation and higher returns have accompanied above average inflation. (There are some exceptions to this statement, but as a general rule it has held true.) Over the last 15 years inflation has been running at 2.1%, below its long-term average of 2.9%. Therefore, it is not surprising that average portfolio returns have also been a bit below average.
However, if the primary goal of investing is to meet current and future spending needs, then low price inflationhelps to offset lower investment portfolio returns. You may have heard the term “real return.” This is defined as a portfolio’s return in excess of inflation, and the concept is intended to help provide a more realistic measurement of how a portfolio’s spending power is truly growing. The good news is that the level of real returns is more consistent throughout history than the level of actual nominal returns. So, even though some individuals with less than ideal inception dates (e.g. 1999 – 2000 or 2006 – 2007) may have experienced a long-term return that is below the historical averages, they can still be on a good track to meet their goals because inflation has also been running below average. As long as low return environments occur alongside low inflation environments, lower than average (or assumed) returns are less likely to threaten the success of financial plans.
We model for a wide variety of investment environments and so long as portfolio returns outpace inflation, individual financial plans can still be successful even if returns run below average. In fact, variables such as the annual savings (pre-retirement) or spending level (post-retirement) have a far greater impact on individual plan success than do investment returns. Hopefully this is great news because how much you save or spend are far more controllable than are investment returns. And this explains why we focus so heavily on these sorts of financial planning topics when we communicate with you. These things matter far more than investment market forecasts or near-term market gyrations.
Hopefully this context is informative and helpful. It is important to observe that even though we can’t predict exactly what investment markets will do, we always seek to add value in the things that we can control in any market environment. This includes maintaining reasonable expenses, identifying an ideal strategic position amongst various investment categories and strategies, as well as doing practical things like taking advantage of tax losses, or trimming things that have performed well recently so that they do not get out of balance.
As always, be sure to let us know your thoughts or questions, either about our approach to return expectations or about how this might relate to your own financial plan.