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October: This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February. ~Mark Twain
I love this quote because it really sums up the risks of speculating in the stock market. At the end of the day, I don’t think there is any way to accurately predict what the stock market is going to return over the next X number of years.[ad#tdg-embedded]
However, the investment industry likes to use historical returns as a simple method of predicting the future. It is simple and easy to explain and meets the needs of those trying to sell investments. Although it varies, I have seen numbers ranging anywhere from 8% to 11% and then the extrapolation that as an investor you need to start investing today to ensure you achieve this so you can return with $1 million or more. If you look at the bottom of each of these peices of marketing material you will see the disclaimer — “Past returns are not a guarantee of future performance”. So what is an investor to use for estimating the stock market return so they can determine how much they need to save today to reach that goal?
To be honest, I still have no idea! However, in perusing my copy of The Four Pillars of Investing and was reminded of Bernstein’s on measuring returns and specifically the Gordon Equation. The Gordon Equation is defined as this:
The Gordon Equation states that the long-term expected real (inflation adjusted) return from the market should approximate the inflation-adjusted compound yearly growth rate in dividends plus the current dividend yield. (Source)
In other words, think of the Gordon Equation like this:
According to Bernstein, the Gordon Equation is the only way to accurately predict future stock market returns. And when he talks about future stock market returns we are not talking about returns 1, 2, 5, or even 10 years from now. We are talking about future stock market returns in the 20+ years time frame. Trying to predict returns for any period less than that is simply speculation.
I think the most valuable part of this chapter in the book is the discussion of what investors could expect in the next 20+ years. The message is that we are not in for the 10% returns that the market has returned in the past and the investment marketing machine still likes to harp on. In fact, based on a current S&P 500 dividend yield of 2.75% and a dividend growth rate of perhaps 4% the future return may be in the neighborhood of 6.75%. That is a far cry from that 10% number.
So what does that mean for us individual investors carving out a retirement plan using dividend stocks and a passive income portfolio? From my perspective it really has two implications on my plan. First, with lower future returns I am going to need to invest as much money as possible into the stock market to make up for the lower returns. Basically it goes like this – higher future returns means less money required up front and on the flip-side lower future returns means more money required up front.
Second, I need to ensure that I am as diversified as humanly possible to attempt to maximize return while minimizing risk. This means that I will diversify my portfolio using a portfolio of ETFs representing large-cap value stocks, small-cap value stocks, REITs and international assets. This will continue to be supplemented by my small percentage of individual dividend growth stocks that I believe have the best chance for future income. In essence, I want to ensure that I at least meet market returns. Investing broadly across various asset classes using index funds is the best way to do this.
When you say “need to ensure that I am as diversified as humanly possible” do you think one can be over diversified if yea how would you determine if you are over diversified?
OK, but we are also hearing the doomsters predicting an L shaped recession with essentially no growth for a decade.
How do you factor that into the Gordon equation. For example, what happens to that equation if you have a relatively prolonged period of deflation?
It would be an interesting exercise to use the Gordon equation to calculate the expected returns of other asset classes.
Jay: this equation takes into acount growth. So in your example, it’s impossible to have “no growth for a decade” if there is a current dividend yield and an expected dividend growth rate. You would have to assume that the current dividend yield is 0% and the dividend growth rate is 0%, which ofcourse is incorrect at current market valuations.
I think this Future Stock Market Returns got really sweet things.
I mostly love this one