Many investors in retirement have certain goals in common: more money rather than less, minimal wealth volatility, and enough financial cushion to cover the extra costs of, hopefully, living a very long life.
Retirees have generally tried to meet those goals with a simple rule of thumb: hold a balanced stock/bond portfolio and withdraw at a sustainable rate. Historically this worked in large part because risk-free rates averaged 5.9% the last 65 years. Risk-free rates form the foundation of expected total return to every risky asset, i.e.:
Expected total return = risk-fee rate + expected risk premium
So, total returns to stocks and bonds were sufficiently high to meet investor needs. After all, if you followed the rule of thumb, withdrawing 4% of your portfolio in retirement when risk-free rates were 5%+, you didn’t need to worry much about running out of money, and you probably ended up having plenty to pass on to your heirs. It was all pretty easy.
Unfortunately, the days of adequate and reliable expected total returns on a traditional stock/bond balanced portfolio could look different. Risk-free rates are near zero or negative in all developed markets, and global yield curves appear to forecast persistently low or negative rates for some time to come. Low or negative risk-free rates can pull down the expected total returns on all investments, stocks and bonds alike.
What about volatility? Volatility is driven by the non-risk-free portion of returns, so it doesn’t decline just because expected total returns are lower. Given the potential new combination of lower expected total return and not lower volatility, simple math tells us that the probability of a low or negative cumulative return over any future period may now be (much) higher in some asset classes. Recent research calls this “The New Arithmetic of Financial Planning” and it represents a direct challenge to traditional retirement analysis.
So risk-free rates have collapsed vs. historical averages, but what about risk premiums? Risk premiums are unknowable in advance, of course, but what’s not unknowable is just how tenuous realized risk premiums on traditional asset classes can be. For example, in Japan the equity risk premium has been negative for the last three decades, and counting. In the U.S., stocks have experienced a worst-case drawdown of 865. And while investors don’t need to be reminded of the 55% drop in their equity portfolios ten years ago, what some may find surprising is that in just the last 12 months, the average small stock in the U.S. is down 9%, and the average international stock is down 1%. Investors are not entitled to the equity risk premium – certainly over shorter periods (10-20 years) and even over periods that many investors typically consider very long term (30 years+).
As we look ahead to the future, it is also interesting to note several of the following which may impact one’s financial planning assumptions going forward:
Historically, the equity risk premium has been reliant on the outsized performance of a small number of companies.
Over the last 93 years, 4% of stocks have driven 100% of U.S. stock market wealth creation. The other 96% are a push.
About 25 stocks (out of about 26,000 ever to exist) have driven 30% of all stock market wealth creation.
Some may ask, where is the next Microsoft and Amazon? Here are a few more thoughts to keep in mind for planning purposes:
Something perhaps not well known to most investors is that companies are staying private longer.
Sarbines-Oxley may be forcing some of this reaction by company executives.
The significant growth in available private market capital is also a reason since an IPO may not be needed.
How can investors capture the hyper-performance in their early few post-IPO years?
Microsoft and Amazon went public with much lower valuations than companies today such as Uber, Peloton and Lyft just to name a few.
While there is a significant amount of data and evidence on this topic, most agree that future expected returns could be lower going forward in some areas of the market. To be clear, lower does not mean negative nor does it imply a forecast for a recession or a stock market crash. However, it may mean that one’s current financial planning or longevity planning assumptions are affected. What this evidence does make pretty clear is the case for smart diversification, risk management, and holistic financial planning.
As always we are here to help.