Earlier this week an article from Bloomberg.com titled “The Next 10 Years Will Be Ugly for Your 401(k)” circulated on Apple news. The article is based on research from California based Research Affiliates and concludes that in an environment of low interest rates for U.S. bonds and high valuations for U.S. stocks, the outlook for future returns from those asset classes is low. Specifically, the article goes on to state that an investor has a 0% chance of earning a real (after inflation) annualized return of 5% over the next 10 years. A link to the article can be found here.
The Joseph Group has referenced Research Affiliates’ work on expected returns in our Investment Committee meetings for years and we are very familiar with the conclusions. With regard to the Bloomberg article we have three key thoughts:
- We strongly agree with the assumption that investing today in expensive asset classes will lead to lower returns in the future. Right now, traditional U.S. stocks and bonds are expensive compared to their history. The benchmark 10-year U.S. Treasury rate is close to historic lows at 1.85% (meaning bonds are expensive) and the normalized price to earnings (P/E) ratio for the S&P 500 is close to its highest level since the tech bubble in 2000 (meaning stocks are expensive). To put what Research Affiliates is saying in the article into Warren Buffett terms – traditional U.S. stocks and bonds simply do not offer much of a margin of safety.
- We also strongly agree with John West, head of client strategies for Research Affiliates. In the article, West states: “To get higher returns, you have to take on what the firm calls “maverick” risk, and that means holding a portfolio that can look very different from those of peers. “It’s hard to stick with being wrong and alone in the short term.” West is saying to get higher returns; investors need to invest differently than a traditional 60/40 U.S. stock and bond portfolio. According to Research Affiliates, this means investing asset classes outside of the United States – specifically developed market foreign and emerging market stocks – which are both assumed to earn real (after inflation) returns exceeding the 5% hurdle referenced in the article according to Research Affiliates’ assumptions.
- The portfolios we manage at The Joseph Group are not the S&P 500 or traditional U.S. stock and bond balanced portfolios. We believe in global diversification and have built our portfolios to have the flexibility to shift into asset classes like emerging market stocks when valuations are low and expected returns are higher. Last year, the S&P 500 was one of the best performing asset class in the world which meant diversification was a “drag” on returns compared to the U.S. stock market. However, if Research Affiliates’ assumptions are correct, globally diversified portfolios, such as The Joseph Group’s Harvest and Abundance strategies, will have an advantage over traditional U.S.-based portfolios.
Our job at The Joseph Group is to stay on top of the numerous things going on in the marketplace and help our clients achieve their goals and dreams. One of those things is to be able to filter information from firms like Research Affiliates who run a large portfolio containing NO U.S. stocks and bonds and therefore could have an agenda behind a scary headline. Another is to get a gauge on future returns and expected inflation and use conservative estimates when we making financial projections for clients. And finally, we need to be willing to create portfolios which may look different from those of peers, but focus on asset classes with lower valuations and higher dividend rates which offer our clients a better opportunity for long-term investment success.