Chances are your financial advisor believes in two related intellectual theories that you should question them about.
In a recent article, the excellent columnist Brett Arends wrote about the two theories governing most financial advisors – the efficient markets hypothesis (EMH) and the capital asset pricing model (CAPM). These sound like impossibly complicated things, but they’re not. The first theory says prices are right, or nearly right all the time, and that it’s, therefore, basically impossible to beat markets. The second theory says historical asset class returns will repeat and that the more risk you take (with risk meaning volatility), the more return you will make. So, for example, stocks are very volatile, but they’ll produce the best returns — something like 10% annualized (or 6.5%-7% after inflation) – over longer periods of time.
But the theories aren’t always right. For example, if stock prices reflect all available information, why are they so volatile, as Arends asks? It may be because that information is always incomplete, and as more information emerges prices change accordingly — and correctly. But extreme volatility may also exist because people are irrational or emotional, and substitute stories or “narratives” for more rigorous analysis or even basic common sense. The rise of the tech bubble, for instance, wasn’t an example of new information being priced in as much as it was an instance of people’s imaginations getting the better of them, andcausing them to inflate the prices of stocks that had no underlying earnings or even revenues.
More problems: why have U.S. stocks (the S&P 500 including dividends) produced a less than 6% nominal return from 2000 through November 2018? Why did they deliver nothing but dividends from the mid-1960s through the early 1980s? And if stocks are such inflation-beaters, why did the S&P 500, including dividends, return only 65 annualized in the 1970s, far underperforming that decade’s inflation?
The facts of the matter are that prices aren’t efficient and asset class returns may not repeat for the, say, 25-year period your retirement plan is counting on them to do so. Bonds returns, for example are easy to forecast. They generally follow the yield-to-maturity. That means a portfolio of 8-year or so domestic investment grade bonds, such as one finds in a fund tracking the Bloomberg Barclay’s US Aggregate Index, now will almost certainly deliver around 3.3%.
And for the S&P 500 Index to return 10% over the next decade, it must trade at a higher P/E ratio than it does now in addition to delivering around a 2% annual dividend payment and 4%-5% earnings-per-share growth. That’s possible, but unlikely, because U.S. stocks are trading at around 30 times their past 10-years’ worth of earnings. They’ve only been that expensive in their runs in 1929 and 2000. Although nobody can be certain, it’s more likely that P/E ratios will decline over the next decade, not increase, cutting into the 6%-7% nominal return from dividends and earnings-per-share growth. Adherents of CAPM, don’t view the world this way, and think prices can keep rising so that it’s almost a long-term investor’s birthright to achieve 10% annualized returns.
If your broker or advisor can’t respond to these objections that their assumed future returns might be off – by a lot – there’s a good possibility that they’re too dogmatic, and have swallowed academic finance without digesting it or thinking about it.
What this means for your portfolio
The problems in these theories mean your portfolio may not be set up to satisfy your financial plan. As Arends mentions in another article, for the decade from 1938 to 1948 a balanced portfolio went backwards relative to inflation. It did the same disappointing thing from 1968 through 1983. With the Federal Reserve taking us into uncharted waters and returns prospects for major asset classes so low, investors should look at cash, real estate, foreign stocks, and commodities, including gold.
None of these by themselves is foolproof. Some of them have performed well in some instances when stocks and bonds have faltered, and others have performed well at other times when stocks and bonds have faltered. The most important thing is that an advisor sensitive to how warped the current market and situation are right now may be your best defense against tepid stock and bond returns. Making sure your advisor hasn’t fallen hook, line, and sinker for the Efficient Market Hypothesis and the Capital Asset Pricing Model may be the best way for you to navigate the next decade or so in the markets.