You couldn’t do a little turn on the catwalk in the 1990s without hearing Right Said Fred’s song about the tail wagging the dog. “I’m Too Sexy” lampooned fashion’s focus on the model rather than the clothes. More and more it seems that financial pundits are performing Right Said Fred Forecasting rather than providing any realistic or actionable information. “Smart Beta” firm Research Affiliates recently put out a study that is summarized by Bloomberg in the article “The Next 10 Years Will Be Ugly for Your 401(k)“. Their prediction tells us more about the forecasters than it does about the future.
The Research Affiliates study gives investors a 0% chance of earning 5% annually for the next ten years with a portfolio of 60% stocks / 40% bonds. This is a great way to catch investors’ attention. We know that negative outlooks carry more weight with people than positive outlooks. A negative outlook also carries with it a sense of expertise while positive outlooks make the forecaster seem naive or inexperienced. This is just human nature. Bad outcomes take up more mental real estate than good outcomes do. This leads to heightened loss aversion which can actually be a bad thing in investing if it prevents the investor from taking on enough risk to meet their financial needs. By saying a 60/40 portfolio won’t earn 5% over the next 10 years, Research Affiliates is not trying to make a prediction about the future. This is part of a marketing campaign to gather assets and sell their products.
Is Research Affiliates right?
Are investors doomed for the next 10 years? Obviously I don’t know what’s going to happen in the next ten years or I’d be typing this from a beach in Antigua, but it’s interesting to look at how Research Affiliates got to their conclusions. They cite low bond yields and high equity valuations as the roadblocks to returns for the next decade. Yields are low, but even if investors earned 0% from their bonds they wouldn’t drag a 60/40 portfolio below 5% if equities earned their historic average return. This is where the high equity valuations some in. Using the Shiller Price/Equity multiple (also known as cyclically adjusted price/equity or CAPE), they see equities as overvalued. CAPE has been thoroughly discredited as a timing mechanic, even by its creator. If you had used CAPE to time the market over the last 20 years, you would have been parked in cash for all but 9 out of the last 240 months. This is not a winning strategy.
The model Research Affiliates used is broken, but let’s go one step further and look at the Vanguard Balanced fund they put forward as a proxy for a 60/40 portfolio. The fund returned 6.6% over the last ten years ending 9/30/2016. Taking out 1.6% for what Research Affiliates calculates for estimated inflation over the next decade, the fund was up 5%. In a ten year stretch that contains the largest drop since the Great Depression, the fund earned 5%. I doubt they are predicting an even larger market meltdown than that in the next ten years.