Reasonable Portfolio Expectations?
Saturday, January 16, 2016
Those who have completed a financial plan are aware that the success of the plan easily depends on the variables used in the calculations'. Yes, there are many other variables that are assumed in a retirement projection. The variables include inflation projections, spending plans, longevity, portfolio return and other variables. The prospective retiree should be aware of these variables and work with a financial planner to see the possible impact of a variance of such variables. While one can adjust some variable such as spending to some extent as you proceed, other variables such as inflation are outside one's control.
One of the big variables is obviously the return on one's portfolio. It is influenced by the portfolio allocation which one can control but also by performance of the markets in general. One of the worst things that can happen, financially to a new retiree, is a collapse of the market such as we saw in 2008. Yes, the stock market has historically recovered but when one is also drawing from the portfolio to meet expenses it becomes more difficult for the portfolio to recover. Actually in the Great recession we were quite fortunate that the stock market recovered rather quickly after 2008. The recovery could have been much slower implying that retirement portfolios would have been depleted more than they were.
Most planning software addresses the potential havoc of a market collapse at retirement by incorporating a Monte Carlo simulation as part of the retirement projection. Rather than project an average return each and every year, the analysis simulates different circumstances by doing thousands of what ifs to determine if the portfolio can withstand the unfortunate event of a market crash especially at retirement.
Todays' financial planning software typically comes with expected sets of rates of return. One, commonly used, could be the historical average for different portfolio allocations. Another could be returns expected given current market valuations and inflation rates. Then these can be adjusted or tested by the financial planner and/or client to adjust for their expectations or test the implications' of a lower or higher return.
The financial planning software I use allows for a differing portfolio allocation for the before retirement years and a different portfolio allocation during retirement.
Recently an article by Michael Kitces makes the case that current financial planning software does not address the historical record. Let me attempt to explain.
Our current stock market as measured by the Shiller CAPE valuation is high. You might remember that Yale professor Shiller wrote the book Irrational Exurban which was published before the tech crash of 2000. The CAPE ratio used by professor Shiller is the current price divided by the average S&P 500 earning for the last 10 years. Since this ratio is over the last 10 years it does not fluctuate as quickly as the current price earnings ratio. Professor Shiller publish another book about the irrational rise in housing prices before the housing crash. So one can say he has a decent track record.
The Kitces article goes on to discuss the track record of the stock market under various CAPE ratios. The article does not really look at the short term record with each valuation. As has been discussed many times the short term performance of the market is really random. It is terribly difficult to predict the short term prices swings in the market. But Mr. Kitces research shows a different story over the longer term. For example, if one looks at the annualized return for the after high valuation point, his research shows an inverse correlation of over 45% CAPE correlation. In other words, the higher the Shiller CAPE ration at the beginning of a 7-15-year time frame the lower the average return over the next 7 to 15-year time period. The good news? After this 15-year time period, Kitces finds the historical returns actually outperform a typical 15-year period.
But yes if you are a new retiree one has to successfully navigate the first 15 years.
What does one take away from this? First, the Shiller Cape ratio at the end of 2015 was 25.9. The only other time the ratio was drastically higher than this was around 1999. So if the correlations remain true the average return for the next 7 to 15 years will be below average even though in the ratio shows no predictive quality in the shorter term. If the correlations remain true then the returns in the second 15 year period will be very good.
Michael Kitces makes the point that financial planning software should incorporate this finding into their software. I am unaware of a current software that has that direct capability.
What does one take away from this report.
- Current market valuations are not cheap
- Can your portfolio withstand an extended period of low returns in the early years of retirement as you draw on the portfolio for retirement needs?
- As 10,000 baby boomers retire each day how much have they considered such a scenario in their planning?
You may contact Ednomics Financial to discuss the possibility of reviewing your retirement in light of current conditions and its possible implications.