If WordPress allowed, I might sub-title this post “the failures of financial economics.”
I’ve been thinking about the announcement earlier this year from the California Public Employees Retirement System (CALPERS) that they were reducing the assumed return on their plan from 7.75% to 7.50%. As noted, I’m very skeptical that such returns will be available in financial markets going forward. Consider the following chart:
If even high-yield bonds won’t provide your target return, and you have bonds as a meaningful component of your portfolio, then you have to assume you are earning much higher returns somewhere else. But where? It seems very unlikely that the stock market will reward you with returns over 7%. I’ve often referenced Shiller’s CAPE, and its robust inverse relationship to future stock market returns:
This is where economists have led plan managers, and others responsible for both projecting and delivering investment returns, astray. Desiring to make their discipline more of a science, and less like accounting, academic finance types treat investment returns as a data set. Look at history, randomize outcomes, and you can project a range of returns or a capital drawdown schedule with confidence to the hundredth of a percent.
The problem is that, when we buy investments, it is the price we pay that largely determines our return. Since investment returns are composed of actual cash flows, they are not a random selection from the span of historical returns, especially at price extremes. On December 31, 1999, near the peak of the tech bubble, projecting returns using the-stock-market-as-data-set methodology suggested a future geometric average return for the S&P 500 Stock Index of over 12%. After all, that was what the market had returned on average since 1926, a nice long period to build your data set.
On the other hand, projecting using the actual cash flows produced by the companies of the S&P suggested a return in the low single digits. (In the event, the average annual return over the next decade was negative at -0.95%.)
Garbage in, garbage out.
This is not a theoretical argument. Just as CALPERS has a fiduciary responsibility to its pensioners and their employers, so here at TGS we have a fiduciary responsibility to our clients, one we take very seriously. Right now, we are doing as much research as we have ever done, looking for opportunities to help our clients earn higher returns.
So far, we think that keeping some cash liquid, hoping to invest it later on at lower prices (and implicitly, at higher returns) is among our best chances to help our clients meet their goals.
There is another issue here, which I’ll address shortly — you can’t assume your way rich. More later.