Predicting future returns in the stock market over a short period of time is impossible. Anyone who is confident in that ability is out to steal your money or about to lose theirs. Predicting returns over a 10-year period is possible with reasonable certainty. In this post I will give investors a framework on determining future returns when making decisions on investing money.
Random Walk Down Wall Street
I got this piece of information from the book “A Random Walk Down Wall Street” by Burton G. Malkiel. I recommend this book to any investor, especially those who have believe they can beat the market. Malkiel through numerous examples shows how difficult it is to outperform the market. Very few do. Identifying those that can is possible, but money managers with such ability may retire by the time they have built an identifiable track record. Peter Lynch, a highly successful investor, retired after 13 years of running the Magellan Fund.
Malkiel showed how by using the CAPE ratio developed by Robert Shiller, one can forecast the stock market return over the next decade. CAPE stands for Cyclically Adjusted P/E ratio. The CAPE ratio is the average price to earnings per share over a 10-year period. Benjamin Graham and David Dodd recommended using a 10-year average in their book Security Analysis as P/E ratios have too much vitality in any given year.
CAPE Ratio as a Predictor of Future Returns
Robert Shiller provides the CAPE ratio for free on his website. As of November 2018, the ratio is 30.57 putting into the tenth decile below.
Referencing the 10th decile on the below chart show a future return over the next decade to be 3.7%. The predicted return is useful as an approximation only. As any financial edge will dull over time as people exploit it. Regardless of how accurate CAPE can predict returns, it will give investors a yard stick for gauging if equities are cheap or expensive.
Predicting Bond Returns
Predicting bond returns over a ten-year period is less of a prediction but rather the investors willingness to hold onto the bond to maturity. Given the risk profile of the bond, the 10-year return is simply the amount of interest plus any capital appreciation or deprecation over that time. Bonds sold have a yield to maturity, reducing the guess work of expected return. If you choose the 10-year US treasury bond yielding around 3%, there will be very little risk of loss on the bond. Agency bonds, backed by mortgage loans and the full faith of the US government, are closer to 4% yield.
Why hold a bond to maturity?
Bonds fluctuate with interest rates. For example, assume the interest that the bond will pay is 4%. If interest rates increase above 4% then the price of the bond if sold will decrease. If an investor buys a bond paying 4% interest at a discount (less than 100% of face value), they will then earn a higher return than 4%. The same applies if interest rates were to fall, the price of the bond would go up above par, called a premium. Any price movement between date of purchase and maturity will be irrelevant if you do not sell. At maturity the investor will earn the stated coupon rate (yield) at time of purchase and the principal (amount paid) of the bond.
With an approximation of returns forecasted over 10 years you can now predict your expected yield on a portfolio. A popular investment allocation is 60% stocks and 40% bonds. With an estimated return on a US Index Fund to be 3.7% using the CAPE ratio and an assumed return on bonds to be 3.5% (taking the average of 3% and 4% discussed above on bonds) you can come up with the blended return. 60% of 3.7% = 2.22%. 40% of 3.5% = 1.4%. The expected returns added together is 2.22% + 1.4% = 3.62% over a decade horizon.