Fox 47- Chesme – How Does a Fiduciary Standard Benefit an Investor?

Low Return Environment?

Michael L. Gay, MBA, CFP®

John Bogle (of Vanguard fame) has a nice, simple model for explaining stock market returns. In his model, market returns can be attributed to three factors:

1. Earnings Growth
2. Dividends
3. Changes in the P/E ( Price/Earnings) Ratio

According to Bogle, the stock market has earned an average annual return of about 9.6% during the past century. That return included earnings growth of 5%, dividends of 4.5%, and a slight increase in the P/E ratio which accounted for the remaining 0.1%.

The question, of course, is whether or not that 9.6% historical average is likely to hold for the foreseeable future. While I’d be willing to bet that the next century will see similar average returns, I’m not willing to bet that the next decade will be quite so rosy. I hope I’m wrong, of course, but each of the three variables appears to be subject to some very strong headwinds that are likely to result in lower-than-average returns for the foreseeable future.

Earnings Growth. Globally, earnings growth is likely to be muted for quite some time as the developed economies attempt to work through the recent financial crises. As Bill Gross noted in an article entitled “You Don’t Get the New Normal”, investors need to learn to expect “half-size economic growth induced by deleveraging, reregulation, and deglobalization. People, companies and countries shedding their debts (will lead to) years of slow economic growth and meager investment returns.”

Dividends. Dividends historically have accounted for a large percentage of stock returns. Unfortunately, dividend yields have been steadily declining. In the early part of the 20th century, dividend yields approached 6%. In the latter part of the 20th century, dividend yields declined to less than 3%. And, as of this writing, dividend yields are averaging around 2%.

P/E Ratios. The P/E Ratio accounts for what Bogle calls the “speculative” component of stock returns. It represents the price that investors are willing to pay for a dollar of earnings. Historically, the P/E ratio has averaged about 15 times earnings. In other words, if a company earns $1 per share, investors have been willing to pay about $15 for that company’s stock.

During periods of market optimism P/E ratios tend to rise as investors become willing to pay more for a dollar of earnings. During periods of market pessimism, P/E ratios tend to fall as investors flee the market.

Currently, the P/E ratio stands at about 16, somewhat higher than the historical average, suggesting that any significant growth in the ratio is likely to be short-lived.

So, let’s take what we know and plug it into Bogle’s formula. Earnings are currently growing at approximately 2.5% annualized. Let’s (optimistically) assume – despite our nation’s trillion-dollar deficits and the reckless policies being forced upon our nation by the federal government – that the economy finds a way to get closer to its historical average and grow by 4% per year. Let’s further assume that dividend yields remain at their current 2% level (since there don’t seem to be any incentives for corporations to increase their dividends, and the only other way to get an increased yield would be to have a decrease in stock prices). So, ignoring the P/E Ratio for a moment, we’re optimistically projecting stock market returns of 6% per year (4% earnings growth plus 2% dividends) – well below Bogle’s historical average of 9.6%.

Now let’s throw the P/E ratio into the mix.

If the P/E ratio expands, future market returns could be higher than our estimate. If it contracts, future market returns could be lower than our estimate. Unfortunately, there does not appear to be much room for sustainable P/E expansion. As I noted earlier, the P/E ratio for the S&P 500 is currently around 16, slightly above its historical average of 15. But the Shiller P/E, which is probably a better measure of Bogle’s “speculative component” because it uses average earnings from the past 10 years, is currently around 23 – well above its historical average of 16.4.

This analysis is consistent with several recent – and more scientific – studies that have attempted to estimate likely future long-term market returns.  For example, in a recent research paper entitled “The Expected Real Return to Equity”, Missaka Warusawitharana (no, I can’t say it either), an economist on the Federal Reserve’s Board of Governors, concludes that current data indicates future average returns are likely to be 1.5% – 3% lower than historical averages.  These results are consistent with several other peer-reviewed research studies.

All of this information suggests that any significant market rallies are likely to be short-lived. It also suggests that currently there is significantly more downside risk in the market than there is upside risk.  Of course, our crystal ball is no better than anyone else’s: Whether the markets return an average of 6% or 9.6% or 12% per year for the next decade is anybody’s guess.  But the smart money, it would seem, isn’t betting on “Dow 20,000″ anytime soon.  $$

Controlling What’s Controllable

Michael L. Gay, MBA, CFP®


Active (Investment) Management is the practice of trying to beat the market by attempting to identify “great” stocks or mutual funds, or by attempting to time exactly when to get in to, or out of, the market. It is the antithesis of Passive Management, which is a buy-and-hold strategy that uses low-cost index funds to simply match the returns of various asset classes. Compared to Passive Management techniques, Active Management is riskier and almost invariably produces lower long-term returns. If you study the objective research, you can come to no other conclusion. As Charles Ellis so eloquently stated, Active Management is a Loser’s Game.

Yet, despite all the evidence, and despite all the harm being done to the typical investor’s portfolio, there is still more money invested using active techniques than there is using low-cost index funds. The question is: “Why?” Why do so many investors pursue the failed practice of active investment management? Certainly, many are simply uninformed or misinformed: There is a powerfully profitable alliance between Wall Street and the popular press which continues to disseminate mountains of misleading investment pornography. But even informed investors – investors who have read the research – often ignore the facts, pursuing active strategies when they know they are likely to make less money than they would if they had invested in simple low cost index funds. But, again, the question is: “Why?”

For some, whether they admit it or not, investing is a form of gambling. Gambling and the tendency to assume unnecessary risks for highly unlikely rewards appears to be a basic human trait. Winning (even if it is by luck) fuels the ego and many investors appear to be happier with an underperforming portfolio that has an occasional “home run” than they are with a portfolio that earns relatively consistent returns but offers little potential for abnormally high gains.

For others, it’s a matter of “belief perseverance” – the tendency for people to hold on to their beliefs even in the presence of contradictory evidence. Not only are people reluctant to search for evidence that contradicts their beliefs, they will most often treat any evidence they do find with excessive skepticism. To some, it must seem impossible that something as seemingly simple (and boring) as indexing could reign supreme over something as complex (and intellectually stimulating) as active management.

Of course, there are many other behavioral issues which cause investors to favor the complex over the simple, and to actively manage their portfolios when the best course of action is to index. Examples are plentiful. There’s self-attribution bias – the tendency for investors to attribute their successes to their own skills (rather than luck) and to attribute their failures to factors beyond their control. There’s overconfidence – the tendency for investors to believe they have keener investment insights than everyone else.

There’s hindsight bias – the tendency for investors to see historical peaks and troughs as obvious and meaningful (when they weren’t and aren’t). And there’s familiarity bias – the tendency to invest in what we know, thus giving ourselves a false sense of control (this is a particular problem for Michiganders who seem to love to put their portfolios at unnecessary risk by owning shares of either Ford or GM). Investors are also prone to extrapolation – the tendency to perceive historical “patterns” as trends when, in fact, they are nothing but random noise.

All of these behavioral issues serve to cloud the reasoning of otherwise prudent investors and steer them away from the benefits of indexing.

But I think, perhaps, the most powerful behavioral issue that perpetuates the active management myth (other than, perhaps, the popular press) is our unrelenting desire to feel in control – even when facing uncontrollable random events (such as the performance of the stock market). Humans are not very good at statistically understanding the world around them. Our brains are programmed to see trends where none exist, to draw conclusions based on incomplete data, and to dismiss the consequences of certain risky behaviors. To most, randomness does not look random (thus the popularity of statistically meaningless “5 Star” rating systems).

So, when someone comes along offering a way to “control” one of the most uncertain aspects of investors’ lives (i.e., stock market performance), active investors gain a great deal of comfort – even when that comfort is a very risky illusion.

In their search for control, and whether they realize it or not, investors who use active techniques actually add more uncertainty to their portfolios; because with active management comes the additional (and almost guaranteed) risk of underperforming the markets. And this underperformance risk can be devastating – especially if it happens to coincide, for example, with an investor’s planned retirement date. A single year of underperformance can easily wipe out a decade of market-beating gains.

Thankfully, trying to control portfolio performance via active management is not a necessary ingredient for investing success. What is necessary, however, is recognizing (and acting upon) what we can control.

If we define success in investing as being able to use our portfolios to meet our most important financial goals, then investors have control over just two variables: the amount of market risk they expose themselves to, and their cash flows (the amount of money they spend, and the amount of money they save). Assuming a diversified portfolio, risk is controlled via asset allocation. The asset allocation decision, in turn, is determined largely by the cash flow variables – planned levels of spending and planned levels of savings.

All else being equal, the more you plan to spend (or the less you plan to save), the more risk you will need to take to meet your financial goals.

So, while investors cannot control the timing of market returns, or whether or not their portfolios will beat the market, they can control the overall level of market risk that they need to subject themselves to: Not by looking for stock-picking or market-timing gurus but, rather, by simply changing their spending and/or savings habits.

Again, the less you spend (or the more you save), the less risk you will need to take to meet your goals. Conversely, if you plan to spend a lot during retirement and are unwilling to maximize your savings, you will probably have to take more risk in your portfolio to try to earn the returns that will be necessary to support your lifestyle.

In other words, closely examining your spending and savings habits (and adjusting your portfolio’s allocation accordingly) can do far more to help ensure you’ll meet your financial goals than trying to identify the next market “guru”, or waiting for the next “perfect time” to reinvest your money. The former – controlling what you can control (i.e., how much you save, how much you spend and your overall allocation) – has an almost 100% chance of succeeding. The latter – trying to control what you can’t (i.e., the timing of portfolio returns via active management) – has an almost 100% chance of failing. $$

The Greatest Hits of Investing

In this article, Brad Steiman of Dimensional Fund Advisors demonstrates how “ . . . investing is like music in that true classics stand the test of time and remain relevant long after they were initially composed.” [Download Article]