In the last installment of Articles on Wealth Management Topics, we discussed academic research on different ways to estimate the magnitude of future stock market returns in an article entitled "Mean Reversion in Financial Markets: The Case for a Contrarian Approach to Investing". As a refresher, the worst of the ways studied was to extrapolate future returns from past returns.
Nearly as ineffective is to base estimates of future returns on surveys of individual and institutional investors. If anything, researchers have found a negative relationship between investor sentiment and future stock market returns. That is, investors as a group becoming more optimistic about the stock market is likely to be predictive of poor returns going forward. This finding is of course another argument in favor of a contrarian approach to discretionary investment management.
It's interesting then that the percentage of American Association of Individual Investors members describing themselves as bullish hit a 3 1/2-year low just a week ago. And money market mutual funds, a traditional safe haven for nervous individual and institutional investors, have attracted more assets in the last 6 months than in any such period since the second half of 2008, when it seemed the financial world was coming to an end. If mutual fund flows are another barometer of investor sentiment, contrarians would argue that this too bodes reasonably well for future stock market returns. As a crusty old bond trader confided to me while a young Wall St. intern more than 30 years ago, "The markets move in the direction that [inconveniences - my word, not his] the most people".
But academic research on estimating future investment returns isn't merely an academic exercise. An estimate of future portfolio returns is a key input into any retirement or education funding projection. Our approach to arriving at an estimate of future returns for use in these projections is ... not to. That is to say that we instead advocate using a range of estimates, rather than an estimate, to stress-test the ability of a portfolio to fund future cash flow needs. This is a particularly important approach in the current market environment, one in which we should expect future portfolio returns to be fairly muted as a by-product of full valuations.
And it's not just the magnitude of future portfolio returns that are relevant to a retiree's financial success. The order in which a retiree experiences various returns also has an impact. So-called "sequence-of-return" risk refers to the fact that recent retirees are particularly vulnerable to bear markets.
Think of those unfortunates who retired in 2007 and 2008 and who were forced to sell investment holdings at very depressed levels shortly thereafter to fund their living expenses. That outsized portion of their retirement nest egg then wasn't around to benefit from the ensuing rebound. For this reason, financial planning projections also need to be stress-tested for adverse sequences of portfolio returns.
Beyond portfolio returns, assumptions underlying retirement projections must be dynamic and revisited through time as unknowns become known. Retirement can be a moving target. A recent TIAA Transition to Retirement Survey polled 1,000 working Americans (ages 55-68) who expect to retire within the next five years. The survey revealed that many respondents have had to change their plans. Only about one-third (37%) plan to retire at the same age as they planned 10 years ago. An equal number (37%) say they now plan to retire later, and almost one-quarter (24%) plan to retire earlier than originally planned. That's why successful financial planning is an ongoing process, not a one-time event.
About the Author
Paul Winter, MBA, CFA, CFP® is a Fee-Only financial advisor and fiduciary in Salt Lake City, UT. His independent wealth management firm, Five Seasons Financial Planning, provides professional portfolio management and objective financial planning services to individuals and families, and to their related entities including trusts, estates, charitable organizations, and small businesses. To contact Paul, please click here.