Avoid the Wolves of Wall Street When Forecasting Investment Returns

We live in a world of nearly infinite, nearly free information. That includes financial information, commentary, journalism, and forecasts. Among this clutter, it can be very hard to decide what deserves attention, what’s worthwhile, and what to believe.

Print, television, and Internet journalism thrives on readers and viewers. In a media landscape that is so crowded, being sensible, useful, and accurate is often boring. Boring is bad for traffic, and bad for revenue. Strong incentives exist to make content (including financial content) exciting and entertaining, rather than valuable.

Similarly, in a marketplace that offers thousands of mutual funds, ETFs, hedge funds, private equity funds, and asset managers competing for “share of balance sheet,” their most urgent competition is for your attention.

Boring doesn’t grab attention.

So, strong incentives exist for all the competitors for your balance sheet to tell you a compelling story. Acknowledging that the future is uncertain is boring. Forecasting near-term massive upside in a particular asset class or near-term macroeconomic doom with an unwarranted degree of certainty is much more entertaining.

Discounting information written for the primary purpose of grabbing attention can help you manage the behavioral tendencies we all have, and make better decisions about your financial planning (and related aspects of estate planning).

The investment return forecasts made in a piece of financial commentary are a “tell” you can use to filter out information created to grab attention.

How might we think reasonably about forecasting investment returns, so as to distinguish reasonable forecasts from unreasonable ones?

You can use two Facts and one Forecast to project real (inflation-adjusted) investment returns. By adding a second Forecast, you can project nominal (gross of inflation) investment returns.

The Facts driving projected investment returns are (1) the dividend yield of a security or a broad market index (the dividends it pays divided by its price) and (2) the current risk-free real rate of return.

Although in the real world no asset is entirely “risk-free”, for present purposes one can use the rate on 10-year Treasury Inflation Protected Securities (or “TIPS”) as a proxy for the risk-free rate.

The Forecast driving projected real investment returns is the dividend growth rate. Because dividends are paid from earnings, sustainable increases in dividends cannot exceed long-term growth in earnings. Because businesses are component parts of the overall economy, it’s reasonable to assume that on average, over time, their earnings will grow proportionally to the overall economic growth rate (itself a Forecast).

The additional Forecast driving projected nominal investment returns is the anticipated inflation rate. The spread between ordinary 10-year Treasury yields and 10-year TIPS yields can be used as a proxy for inflation expectations.

(If you’re a finance person or simply enjoy following a much more detailed, in-depth application of this methodology, read “What Risk Premium Is Normal?” a 2002 Financial Analysts Journal article by Robert Arnott and Peter Bernstein.)

We can use this approach in a case study projecting global equity returns using the FTSE Global All Cap Index (a capitalization-weighted index of approximately 7,400 publicly traded stocks).

The current dividend yield on the Index is 2.34%. According to the Conference Board, estimates for global long-term economic growth are about 2.7% to 3.3% (let’s be cautious, and use the lower value in this example). The current 10-year TIPS yield is approximately 0.15%.

Together, this suggests that a reasonable overall real global equity market return projection is:

To project nominal (gross of inflation) equity market returns, add the spread between ordinary 10-year Treasury yields and 10-year TIPS, which reflects the market’s inflation expectations. (Current 10-year Treasury yields are 1.85%, so the spread is about 1.6%.)

Treasury yields and economic growth forecasts are always changing. Dividend yields change too, as dividends increase (or fall) and security prices rise and fall. The results produced by this approach, accordingly, will always be changing.

Nonetheless, I think the approach is a reasonable framework for evaluating other investment return Forecasts that come across the transom.

It is not uncommon for competitors for “share of balance sheet” to tell readers or listeners what they want to hear:

• “This asset class is poised for wild outperformance.” Maybe so – but if so, why? What is the risk exposure associated with the opportunity to outperform?

• “Other asset classes are about to crater; buy this asset class as a safe haven.” Again, maybe so, but if so, why, and what are the opportunity costs associated with surrendering exposure to the suspect asset class?

• “Your returns will be so good you won’t have to make tough choices.” Saving is difficult, and everyone wants to achieve lifestyle goals. Strong investment returns can offer a shortcut to those goals, reducing the need for unattractive tradeoffs.

A desire for shortcuts doesn’t change the enduring investment truth that outsize returns are associated with outsize risks. Clients should always remember that telling people something that’s easy to hear rather than a reasonable forecast is tempting, if one is trying to increase assets under management.

Although entertainment is great (and The Wolf of Wall Street was extremely entertaining, although more than a bit vulgar…) smart life cycle estate and financial planning isn’t about entertainment – it’s about reaching important goals for yourself and others who matter to you.

The more you know about the drivers of long-term investment returns, the better positioned you will be to use quality forecasts to make better savings, spending, and wealth transfer decisions.

KYEstates does not provide investment advice and does not recommend the purchase or sale of any security. A detailed disclaimer is available here.

Image above © Paramount Pictures. Fair use rationale: critical discussion of its film The Wolf of Wall Street. For detailed rationale, see here.