Opinion: The most important predictor of your financial security in retirement
The biggest determinant of the performance of your retirement portfolio in the years to come is the performance of the stock market.
The bond market is just behind. Everything else pales in comparison.
It’s crucial to keep this in mind, as it focuses your attention on what will make the most difference to your financial security in retirement. You can be an excellent market timer, for example, or a brilliant picker of stocks, ETFs, or mutual funds, but you’ll almost certainly make less money in bear market years than you would. by being a horrible market timer or stock picker during the bull market. year.
These comments were prompted by the latest update to Vanguard’s annual directory, How Americans Save. The big data in this directory includes returns investors have earned in their 401(k)s and IRAs. As you can see from the accompanying graph, their returns in each of the last five calendar years are very closely correlated to those of a balanced portfolio of stocks and bonds (either a 60/40 or 70 /30).
It is always possible that Vanguard’s clients are not representative of investors in general. But I doubt it. The data in this latest yearbook reflects the experience of 4.7 million defined contribution (DC) plan participants at Vanguard. It’s a huge sample.
The investment implication is clear: you should base your financial plan for retirement on a realistic forecast of long-term stock and bond market performance. If the forecasts you use are too optimistic, you will definitely not achieve your financial retirement goals, no matter what else you do well.
Future bond yields
So what is a realistic long-term forecast? Let me start by focusing on bond funds because their long-term returns are easier to project than those of stocks. In fact, we know with great certainty what their returns will be, regardless of how interest rates move.
Indeed, almost all bond funds use what are called ladders, which maintain a more or less fixed average duration for their bond holdings. This means that each time a bond they hold matures, they reinvest the proceeds in another bond of a duration long enough to maintain that overall average. Researchers have derived a formula that predicts with a high degree of confidence what the long-term performance of a ladder will be..
Under this formula, as long as you hold the bond ladder for one year less than twice its target duration, your total return on an annualized basis will be very close to its starting return. The researchers who derived this formula are Martin Leibowitz and Anthony Bova, managing director and chief executive of Morgan Stanley, respectively, and Stanley Kogelman, director of New York-based investment advisory firm Advanced Portfolio Management.
Their formula works because, as interest rates rise, newly purchased bonds that replace maturing ones will have progressively higher yields. Provided they hold out long enough, these high yields will offset the capital losses suffered by previously held bonds as rates rise. I discussed this formula at greater length in my Retirement Weekly column last March.
Consider what this formula means in the case of the iShares Core US Aggregate Bond ETF [TICKER AGG], which is benchmarked to the broad US investment-grade bond market. Its current average duration is 6.55 years, according to iShares, and has an average yield to maturity of 1.41%. As long as you hold AGG for 12.1 years (6.55 times two, minus one), your return will be very close to 1.41% annualized, regardless of the level of interest rates in the meantime.
Future stock returns
If only predicting long-term stock returns were that easy.
In my view, the best we can do for estimating long-term stock returns is to rely on the indicators that historically have had the best track record for predicting. For this column, I have focused on eight of these indicators which, as far as I can tell, are above all the others. I listed the eight in a column two weeks ago.
Each of these eight indicators currently predicts that the S&P 500 SPX,
over the next decade will produce returns well below average. The median forecast of the eight is an inflation-adjusted total return of minus 2.8% annualized. If we add in the Breakeven inflation over 10 years (the bond market’s best estimate of what average inflation will be over the next decade), we get a forecast of minus 0.5% annualized by 2031 – essentially, a forecast that the stock market, even with dividends added, will be no higher in ten years than it is today.
You should know that this forecast comes with a large margin of error. But the investment implications are profound if this forecast comes even moderately close to accuracy. In this case, a 60% stock/40% bond portfolio would yield a nominal return of 0.3% annualized over the next decade, and a 70%/30% portfolio would yield a nominal return of only 0.1% annualized.
It could be devastating for many retirees and near-retirees if this prediction turns out to be correct. But that’s no reason to reject it. Hoping for the best is not a viable strategy.
I think the best part of wisdom is to base your financial security in retirement on the assumption that this forecast is accurate, making whatever adjustments to your standard of living in retirement that would entail. If the markets turn out to produce much better returns, you will be pleasantly surprised and can then spend your windfall.
For my money, I’d rather be pleasantly surprised than not. Warned is warned.
Mark Hulbert is a regular MarketWatch contributor. His Hulbert Ratings tracks investment newsletters that pay a fixed fee to be audited. He can be contacted at email@example.com.