This is part 2 in a 7 part series on designing your portfolio. In part 1, we discussed how to set a specific goal for your portfolio and introduced the “future value” spreadsheet function. In this part, we’ll begin discussing the concept of asset allocation and further explore the future value function and especially the relationship between how much you need to save, your portfolio return, and time.
The Yin and Yang of Future Value
Open up your spreadsheet again and put this future value function into a cell.
This function says that if you start with nothing (0) and save $60,500 a year for 20 years, and earn 5% after-inflation each year, that after 20 years you’ll have $2 Million in today’s dollars. Now, $60K seems like an awful lot of money to save each year. I mean, you’re only making $200K, you’ve got a fat mortgage, 2 kids in private school, a high tax bill, and payments on the Porsche to make, right? So what other options are there to get to that $2 Million figure?
The four terms are all dependent on each other, but this concept is so important to your investing plan that we can’t spend too much time on it. Let’s say you can only save $30K a year. Let’s assume you still don’t have anything to start with and you still earn 5% real on your investments. How long is it going to take to get to that $2 Million figure?
An extra 10 years. Hmmmm. Now you’re deciding between that big house with the expensive mortgage versus working 10 years longer. What other options do we have?
Well, you could get an inheritance, so let’s say you have $300K in your retirement accounts already. How long do you have to work now if you save $30K a year and earn 5% real?
Now you get to $2 Million in just 21 years and 9 months.
But what if you OWE $300K in student loans (let’s assume 0% interest, just to keep things simple) and really want to retire in just 25 more years? How much do you need to save/use to pay down loans each year?
It turns out $63,200 per year.
You can play around with this function yourself for a little bit just to get an idea of what is possible.
What About Return?
Well, that’s pretty cool, you say. Don’t you feel empowered now? Now you too can generate all those fancy charts and graphs financial advisors like to wow you with. But there’s one factor in that function that is much harder for you to control- your return. Wouldn’t it be wonderful if you could just double your return? For example, let’s say you only want to save $30K a year, you have nothing now, and you still want to retire in 20 years? What kind of return do you need? =FV(11.3%,20,-30000,0) 11.3% It seems a lot easier to just get that 11.3% return than to sell the Porsche or live in a small house, doesn’t it? Why not just do that?
Source of Returns
The source of your return is the financial markets. Market returns are impossible to predict, much less control. This goes for the stock market, the bond market, the real estate market, the commodities market or any other market you want to invest in. You can control the amount of risk you take, but that only has a moderate amount of correlation with your actual returns. It is important to understand the concept of expected returns. Your expected return is what you expect to get for a given level of risk, on average, over many years. Even over many years there are no guarantees, especially given the complex economic and political changes that occur frequently around the world and in your own city and country. But if you have no idea what to expect, you can’t possibly estimate how much you need to save.
One source you can look to for estimating your returns is the past. As every investment prospectus is required by law to mention, past returns are no indication of future returns. But they do help define a range of possibilities. Let’s take a look at the US Stock Market for instance. If you invested in the low-cost Vanguard 500 Index fund 36 years ago, your average annualized nominal (before-inflation) return would be 10.47%. Inflation from October 1976 until now has averaged about 3.85% since that time, so the real return of the US Stock Market (including dividends and subtracting out very low investment costs) is 6.62%. So if the future is like the past, and you invest in a 100% stock portfolio, you could use an expected return of 6.62% in your calculations. Note how different this number is from the 11.3% discussed above. That really demonstrates how unrealistic the plan to only save $30K per year and to retire in 20 years on $2 Million is. Even if you got this 6.62%, you would fall $820K short of your goal.
What about bonds? Vanguard started their “Total Bond Market Fund” 22 years ago. The average annualized return since then has been 6.85%, a real return of 4.17%. If we use that as an expected return then a portfolio of 50% stocks and 50% bonds would expect a return of 5.40%, not counting any rebalancing bonus (more on that later.)
We do have more data on long-term stock and bond returns, with the best data set going back to the 1920s and some even going back a couple of hundred years. But those numbers aren’t all that much different than what we’ve discussed above.
Another way to look at returns is from a theoretical perspective. If a bond investor really expects 4% real returns going forward from this point, most authorities would tell him he’s crazy. Part of the reason for the relatively good bond returns over the last 22 years is that interest rates have been falling, giving bond returns a nice tailwind. At the end of 1989 10 year treasury bonds were yielding about 8%. Now they’re yielding less than 2%. The best predictor of future bond returns is the current yield, and that’s a nominal (before inflation) number. Given current inflation rates, that means our current expected real bond returns are -1%. Pretty depressing huh.
You can also estimate real stock returns theoretically. The most common way is the discount dividend model. You basically add the expected dividend yield to the expected GDP growth. There is a speculative factor as well, but over long time periods, that can generally be ignored. Current yield of the S&P 500 is about 2%. Economists are estimating around 3% for the long-term GDP growth. Add those together for a 5% real return.
Using these theoretical returns, we can calculate the long-term expected real return for a 50% stock, 50% bond portfolio at 2%.
Take More Risk
Now, there are ways to take on more risk in hopes of getting more return. You can invest in a stock-heavy portfolio and even include riskier stocks which theoretically have higher expected returns, such as microcaps, small value stocks, or emerging market stocks. Real estate also promises some higher returns, especially given current low interest rates and the recent decrease in real estate prices. But the bottom line is that the expected after-inflation return number you should use in your portfolio return calculation is somewhere between 2 and 7%. If you (or your advisor) are making calculations using 10% or even 12%, your plan is probably doomed to failure.
Back To The Future
Let’s return again to the future value function. If you want $2 Million in 25 years and have nothing now, you’ll need to save somewhere between $65,500 (2% returns) and $31,700 (7% returns) per year. The riskier your portfolio, and the more optimistic you are about the future economy, the less you can save. But putting away $20K a year just isn’t going to cut it, and $50K might not even be enough.
So step one in designing a portfolio is setting specific goals. As you begin to implement an asset allocation to reach those goals, it is important to realize the relationship between how much you need to save, and how much of the “heavy lifting” your portfolio will provide through its compounded returns. See why I said “If you don’t know how much you need to save you won’t save enough?” A comfortable retirement requires far more savings than most people think.
Part 3 will discuss how to choose asset classes to include in your portfolio.