But most investors are surprised to learn that a diversified portfolio’s results falling around the hallowed CPI + 5% is an unusual outcome, at least on an annual basis. Figure 1 displays the calendar year real returns for the 16-asset class portfolio, with the 60/40 asset mix thrown in for good measure. Note the dearth of examples—only 3 in 25 years—where the equally weighted portfolio finished in the seemingly wide range from 3% to 7% above the rate of inflation. The 60/40 investor also came within 2% of the 5% real return target only twice. It just doesn’t happen very often. Instead, the capital markets provide a feast-or-famine history of big “up” years, offset by modest to severe shortfalls, often during crisis periods. Real returns that are negative or soar into double digit territory are more common than returns between these two poles! The average isn’t normal.
Of course, past is not prologue. The next 25 years are unlikely to resemble the past 25 years. So investors shouldn’t count on historical long-term returns, as these numbers were universally built on much higher starting yields than we have today. The average real yield on intermediate Treasuries and TIPS over the past 25 years has been a shade under 3%.4 Thus, while they fluctuated wildly on investor sentiment and macroeconomic drivers, all risk premiums—credit spreads, equity valuations, etc.—were priced off a much higher risk-free real rate. All one needed was an extra 2% from risk premium or alpha! Today, real yields are essentially zero. So both of the simple mixes illustrated are unlikely to achieve long-term returns in the CPI + 5% range. The mean will come down.
Are Valuation Levels Offering a Fat Pitch?
For the tactically inclined, the annual distribution of returns is likely to remain wide even with a lower expectation.5 This is important. If we can capture a decent share of the large up years, and rein in the losses in bad years, meaningful real returns can still be earned. This requires careful attention to the “risk dial.” As Warren Buffett famously said early in his career, we should be “greedy when others are fearful and fearful when others are greedy.”
With a flexible and less constrained approach, we can systematically expand our risk appetite when assets are cheap and investors are terrified, and move to a conservative posture when complacency reigns and investors are “picking up nickels in front of a steamroller.” The most successful investors are those with the discipline to bypass risk when the markets seem tranquil, and the fortitude to step up and buy assets when they are shunned by others.
Today, markets appear increasingly benign, shrugging off some notable long-term headwinds (see our papers on the “3-D Hurricane” and “Unreal GDP,” for example). Let’s review the S&P 500 and REITs, two of the top performing (and more pro-cyclically oriented) assets in recent years. Leading all assets over the past three years, REITs have produced a cumulative return of 79.9% since January 31, 2010. The S&P 500 finished third with an advance of 48.7% for the same period. (The related Russell 2000 Index, a proxy for small U.S. companies, unsurprisingly finished between these two with a 56.0% return.)
When assets experience such substantial price appreciation, we often observe two distinct yet interrelated cautionary signals. First, investors’ risk aversion declines. Our CIO, Jason Hsu, often talks about time-varying risk aversion on the part of investors. In other words, their tolerance for volatility rises after a period of economic growth and robust stock market returns. Like gamblers with large winnings, investors tend to be more aggressive when they think they are “playing with house money.” We see this trend when we look at annualized volatility data. As Figure 2 shows, equities have trailing 90-day annualized volatility of 12% versus an average of 17% since 1993, and REIT volatility has reached levels not seen since 2003. Playing with house money indeed!