- Portfolios dominated by mainstream asset classes have a very low probability of earning a 5% annualized real return over the next decade, but most investors are blithely overlooking this reality.
- A comparison of the most popular investing strategies used to build retirement nest eggs suggests the chances of any producing a 5% annualized real return for investors over the next decade is quite slim. Portfolio alpha and/or alternatives allocations are unlikely to change this conclusion.
Now’s the time to get real. Now’s the time, in a world of paltry bond yields and meager dividends, to make an honest assessment of your portfolio’s long-term expected return. We encourage you to take the 5% Challenge by visiting our website where you can create a portfolio using our interactive portfolio builder to replicate your current allocation or a contemplated allocation. What are the odds your portfolio will earn an annualized real return of 5% over the next decade?
A Lesson from Lloyd
In a fast-paced life, John and his wife often enjoy some mindless entertainment downtime. No suspense. No sophisticated plot. No worldly foreign-language subtitles. Just…mindless. And it would be hard to get much more mindless than the Farrelly brothers whose signature movie Dumb and Dumber always seems to be on cable during the downtime hour. In this 1994 comedy, two nitwits—Lloyd Christmas and Harry Dunne, played by Jim Carrey and Jeff Daniels, respectively—follow beautiful Mary Swanson (Lauren Holly) to Aspen after limo-driver Lloyd falls in love with her on an airport drop-off.
After the requisite road trip hi-jinks, Lloyd finally catches up to Mary in Colorado and gets the nerve to ask her his chances. The conversation goes like this:
Lloyd Christmas (Jim Carrey): What do you think the chances are of a guy like you and a girl like me…ending up together?
Mary Swanson (Lauren Holly): Not good.
Lloyd: You mean, not good like one out of a hundred?
Mary: I’d say more like one out of a million.
Lloyd: So you’re telling me there’s a chance.1
Now that’s truly looking at life through rose-colored glasses!
We have to say we see a lot of similarities between Lloyd’s unfounded optimism and that of many investors in believing their mainstream portfolios will hit their targeted long-term return—for many, a real 5%. As Mary Swanson clearly told Lloyd, chances of reaching that return are “not good.” Instead of taking action, most investors ignore this seemingly straightforward conclusion. Like Lloyd Christmas, they don’t care if the probability of failure is high. A miniscule chance is good enough. Worse yet, many investors attempt to close the gap by making alpha bets, exposing their portfolios to the return-eroding performance chasing that so often goes hand-in-hand in such a pursuit.
What Are Your Odds of Dating Mary?
In 2014, we began publishing our 10-year expected risk and return forecasts for a broad spectrum of equities, bonds, commodities, currencies, and REITs. Our objective was to provide investors our best thinking on long-term return forecasts. A year later we released a portfolio builder, available on our website, that allows investors to build and compare the 10-year expected risk and return of customizable, diversified portfolios.
In an industry dominated by promises of higher return, investors need to ask higher than what? The question we should be asking about our long-term portfolio management goals is not simply what return are we likely to earn over the next decade, but is the return likely to cover our spending needs when the decade comes to an end. What are our odds of eclipsing the hurdle rate necessary to accomplish our goals, or in Lloyd-speak, what are the odds of getting a date with Mary?
To uncover the hurdle rate most investors are banking on to meet their financial needs in retirement, we surveyed the default returns embedded in 11 retirement calculators, robo-advisors, and institutional investor surveys built on hundreds of underlying participants.2 The average and median annualized long-term expected returns were 6.2% and 6.0%, respectively. We can translate these nominal forecasts into real, or after-inflation, returns by subtracting a market forecast of inflation; we use the yield difference between 10-year US Treasuries and 10-year US TIPS, better known as breakeven inflation (BEI). The appendix to this article discusses real and nominal returns.
As of September 30, 2016, 10-year BEI was 1.6%. Reducing the nominal 10-year average and median returns of 6.2% and 6.0%, respectively, by 1.6%, we find the real average and median targeted returns from our retirement survey to be 4.6% and 4.4%, respectively. Rounding up, we arrive at 5.0%. If investors are counting on earning a 5% real return, what are the odds they will be able to do it?
Before we apply our expected return forecasts to test the reality of this hurdle, allow us a quick caveat. Perfect foresight eludes us. But we do know a good forecast includes a component that attempts to model unexpected return. To capture the variability in our expected return over the next 10 years, we create a forecast based not on a single point estimate, but on a full distribution of possible future outcomes. The expected return is simply the mean of that distribution. Where a 5% real return lands on this distribution allows us to derive the odds of achieving, or improving on, this level of return.
The classic 60/40 portfolio. Let’s start with perhaps the most comfortable portfolio to own, the good ole 60/40 blend of US stocks and bonds. It’s had a remarkable run. The Vanguard Balanced Index Fund, which aims to replicate a 60% US stock index and 40% US bond index, has delivered a 10-year return as of September 30, 2016, that places it in the top decile of balanced mutual funds. But from today’s vantage point with US bond yields exceptionally low and equity P/E ratios (determined using the Shiller P/E multiple) in the top decile of a 100-year history, future returns are likely to be extremely muted.3 How muted? We estimate the ubiquitous 60/40 US portfolio has a 0% probability of achieving a 5% or greater annualized real return over the next decade. Yep, you heard us correctly. Zero. Well, that’s not entirely accurate. If we extend to another decimal, the rounded 0% becomes 0.2%. So you’re saying there’s a chance!