On a discussion board someone commented on my post Modeling Expected Future Returns that modeling expected returns “is a fool’s errand.” He then went on to tout some company’s terrific annuity product.
Never mind the company or the product he was touting, I suspect a lot of investors feel similarly, that modeling expected future returns is a waste of time.
Here’s why it’s not a waste of time: any allocation you make reflects SOMEBODY’s return and risk expectations, whether you realize it or not. So even if you’re not doing the modeling someone else is, but you could end up paying the consequences if they’re wrong for too long.
Returns might fluctuate, but we’re not totally blind about the long run
While returns fluctuate and nobody can consistently forecast short-term returns, extreme valuation levels have a profound say in future results for up to a decade or longer. Do you recall the value-minded pundits telling us back in 1998-1999 that the market was overvalued and that equities, particularly Technology stocks, would offer lousy returns for up to a decade?
Two examples stand out in my mind.
Gerry Scriver, who hired me at Westpeak, was featured in Barron’s final regular issue of 1999. The writer clearly didn’t know what to make of Gerry, who was steadfast in refusing to participate in the internet mania. Chances are nobody who was pouring their cash into NASDAQ stocks even bothered to read the article as the bubble wouldn’t burst yet for another 10 weeks.
Your investments reflect somebody’s return expectations – but whose?
Investors and advisors today cannot simply sleepwalk, filling out stylebox grids to complete a client’s allocation. The economic forces our investment capital faces could be profoundly different from those of the past: developed country populations are aging, which suggests
- Fewer participants in the workforce
- Capital being withdrawn from equities
- A growing incentive for governments NOT to permit excessive inflation
Demographics aside, there’s the headline matter these days of governments reining in their spending. So if you’re simply acquiescing to the conventional 60/40 mix, or according to some other target-date recipe, ask yourself who decided this was the right mix? Based on what return and risk assumptions?
Target date funds: Do their glide paths adjust for changing expectations?
If you buy a target date fund, recognize that its construction was (hopefully) based on a set of return and risk assumptions at the time of inception. Chances are investment professionals employed by the sponsor have changed their own return and risk expectations; does the fund remains locked into sticking to its original glide path? Check its newer funds’ glide paths and compare their terminal allocation paths to yours. Target date fund sponsors have products to sell, and the right one for you today might not be the right one for you in a few years, so ask whether you ought to lock yourself in.
Annuities: How much are you really guaranteed?
If you buy an annuity, even though you’re not the one engaging in the “fool’s errand” of modeling risk and return, the underwriter of your annuity is, and you better hope your underwriter is not a fool. In addition the underwriter is also modeling your longevity, along with the longevity of millions of other customers.
So here’s the wrinkle with letting the annuity underwriter bear all that risk: ultimately you might still be bearing the risk yourself. Because if the underwriter gets it wrong, really wrong, and it turns out years down the road that the underwriter’s bets were wrong or unbalanced, or it mistakenly expected you and its other customers to die sooner than you eventually do, your future income could be at risk. Make sure you understand what amount of your annuity is protected by the appropriate State Guaranty Association.
Even if you choose not to model expected returns, make sure you know who is.