Slow failure in investing happens when portfolio returns are insufficient to generate the growth needed to meet your objectives. No one event causes this type of failure. Rather, it slowly builds over time. Think death by a thousand papercuts or your home slowly being destroyed from the inside by termites.
Traditionally, this type of slow failure was probably the result of taking too little risk. Oversized allocations to cash, which as an asset class has barely kept up with inflation over the last 90 years, are particularly likely to be a culprit in this respect.
Take your average 60% stock / 40% bond investor as an example. Historically, such an investor would have seen a $100,000 investment grow to $1,494,003 over a 30-year horizon. Add a 5% cash allocation to that portfolio and the average result drops to $1,406,935, an $87k cash drag. Double the cash bucket to 10% and the average drag increases to nearly $170k. This pattern continues as each additional 5% cash increment lowers ending wealth by approximately $80k.
Ultimately, this was not a problem for many investors who relied on balanced portfolios, as a 60% stock / 40% bond portfolio averaged 8.3% before inflation and 5.1% after.
Unfortunately, today’s investors face a more daunting problem. Low returns may not be limited to cash. Below, we present medium term (5 to 10 year) expected returns on U.S. equities, U.S. bonds, and a 60/40 blend from seven different firms/individuals. The average expected return on the 60/40 portfolio is less than 1% per year after inflation. Even if we exclude the outlier, GMO, the average expected return for the 60/40 is still only 1.3%. Even the most optimistic forecast from AQR is downright depressing relative to historical experience.
And the negativity is far from limited to U.S. markets. For example, Research Affiliates forecasts a 5.7% real return for emerging market equities. This is their highest projected return asset class and it still falls well short of historical experience for the U.S. equity markets, which have returned 6.5% after inflation over the last 90 years.
One immediate solution that may come to mind is just to take more risk. For example, a 4% return after inflation, which is what most retirement calculations are based on, may still be technically achievable. However, assuming that the above forecasts are relatively accurate, this still requires buying into and sticking with a portfolio that holds around 40% in emerging market securities, more than 20% in real assets/alternatives, and exactly 0% large-cap U.S. equity exposure.
This may work for those early in their careers, but it certainly would require quite a bit of intestinal fortitude. For those nearing, or in, retirement, the problem is more discouraging. Larger losses in the years prior to and right after the retirement age can cripple a portfolio permanently – a phenomenon known as sequence risk.
Rather than simply taking on more risk in search of higher returns, investors are better served by implementing marginal improvements, with their wealth manager’s help, that compound on each other.
No one can control the returns of U.S. stocks or bonds (or any asset class returns for that matter). But you can take control of the factors that you can influence.
For a current or future retiree, this means:
Retirement success and muted future returns are not mutually exclusive. However, achieving financial goals in such an environment requires careful planning for factors that may have been safely ignored given the generous market tailwinds of prior decades.
About the Author: Justin Sibears is a Portfolio Manager at Newfound. A frequent speaker on industry panels and contributor to ETF Trends, Justin holds a Master of Science in Computational Finance and a Master of Business Administration from Carnegie Mellon University as a well as a BBA in Mathematics and Finance from the University of Notre Dame.
About Newfound: Newfound is a Boston-based quantitative asset management firm focused on rules-based, outcome-oriented investment strategies. Newfound specializes in tactical asset allocation and risk management solutions. Founded in 2008, Newfound offers a full suite of tactical ETF managed portfolios covering global equity, U.S. small-cap equity, multi-asset income, fixed income, and alternative asset classes.
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The information and opinions contained in this material have been produced by Newfound Research and though they are derived from sources deemed reliable, are not all-inclusive and are not guaranteed as to accuracy.
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