Financial Planning Is Forecasting

by | May 28, 2021 | Financial Planning, Investments, Retirement Planning

Too many forecasts are projections of what just happened. Think of cable news during periods of market volatility. It’s overly simplistic and not very helpful. Then add to that the refrain common of every investment disclosure ever created: the past does not predict the future.

The future is unknown and we live it as it unfolds. Yet, a critical part of financial planning is developing and implementing an investment strategy that will deliver results that support your goals. This requires estimating expected risk and return. If your plan calls for a return of 7% per year for ten years, well then, you need to invest in assets you expect to deliver that return. Central to investing is applying knowledge and analysis to the uncertainty of the future.

So, the question becomes, how do you estimate what will deliver the returns you need?

We turn to a simple model. The late, great Jack Bogle (Vanguard Founder) developed an easy-to-use system for forecasting future returns. He laid it out in a research paper, Occam’s Razor Redux: Establishing Reasonable Expectations for Financial Market Returns. Bogle’s model looks at the S&P 500’s current dividend yield, average 10-year earnings growth, and is based on the assumption that the future P/E ratio will revert back to its 30-year mean.

A time-tested predicative model can provide historical perspective and insight into the future as we construct and manage our portfolios. It’s all about establishing reasonable expectations. So, while you should not expect your projections to be 100% accurate, and it’s entirely possible that they will be flat-out wrong, diligent planning requires that you leverage a deep knowledge base to make informed forecasts to guide your decisions.

Disclaimer

Before you read on, PLEASE NOTE: Everything that follows is for illustration purposes only. It is in no way, shape or form a guarantee. It is likely the future will be much different than what is noted below. In fact, you should expect it to be wrong. We have no idea of what the future holds. No one does.

The simple components of return

Back to Bogle’s model. The three components mentioned above can be described as earnings growth, starting yield, and the price someone is willing to pay. The expected return is calculated by adding up the current dividend yield, growth in earnings, and the expected change in price multiple.

Let’s look at each of these components and see how they apply to the S&P 500. For our example, we’ll set a ten-year forecast horizon.

Starting yield

Yield is a fancy term for dividends. Dividends are what we’re paid for owning stocks. According to Ycharts.com, the current average dividend yield for the Vanguard S&P 500 ETF is 1.4%. The average dividend is the starting point for our forecast.

average annual dividend yield

Earnings yield.

Earnings is the growth component of our equation. According to multpl.com, the earnings of the companies making up the S&P 500 have grown at a median rate of 10.68%. That’s closely in line with the 1926-2021 annualized return of the S&P 500, which is 10.38%.

But we’re concerned with future earnings growth, and over a shorter time period, particularly since most time horizons are less than 100 years.

Earnings growth has many components, but it all starts with the economy. Without a strong economic environment, earnings cannot be expected to grow very fast. Additionally, we could factor in inflation, technological advances, and global political disruptions. It’s pretty easy to make this complicated. And we introduce a greater chance for error with each additional variable we include, so let’s keep it simple.

While our investment plans may not last 100 years, we can gain some predictive insight for future earnings growth by using historical averages. According to multpl.com, since 1901, S&P 500 earnings have grown an average of 6.16% per year since 1900.

As you can see below, growth has ranged between 0.34% and 21.10%. Given all that data, 6.16% seems to be reasonable, which is what we’re shooting for.

average annual earnings growth

Change in price multiple.

The change in price multiple is dependent on the movement of the market. This is the truly speculative component of our return equation since we have no idea what prices people will want to pay in the future. But we do know that if we pay a high price today, a low price in the future will hurt our returns.

One of the most common equity analysis tools is the price-to-earnings ratio, or “P/E ratio”. The P/E ratio measures how much investors are willing to pay, today, for one unit of earnings. Currently, Vanguard lists the P/E of its S&P 500 ETF (VOO) at 27.9X. That means for every $1.00 of earnings investors are paying $27.90.

Below are the S&P 500’s P/Es per decade going back to 1900.

average annual PE ratio by decade

average annual PE ratio by decade

Our goal is to generate a reasonable estimate for what the multiple will be in the future. If investors are more manic, the P/E will be higher than today. If they are more depressive, the P/E will be lower.

Many analysts suggest a straight-line average based on history. The average P/E ratio for the past 100 years is 16.01X. If over the next 10 years the S&P P/E ratio reverts back from 27.9X to 16X, it would result in an annual return drag of 5.4%, basically eliminating all of our expected earnings growth.

But as seen above, over the last 30 years, the P/E has been sustainably higher than 16X; since 1990, the average has been a P/E of 23.77X. For our illustration, let’s expect the future P/E will be 24X.

Creating an estimate.

We have twelve decades of data to reference. Using that, we can make a projection of the future returns of the S&P 500.

To provide some support for this projection, let’s look at the projected return our model produced for the 10-year periods ending 2020, 2010, 2000 compared to the actual returns.

SP last years PE ratio

SP last years PE ratio

Seeing as there is some efficacy to our model, we’ll use it to forecast estimates for the S&P 500 annual returns for the ten-year period ending in 2030.

First, we’ll add the current dividend yield to the long-term earnings growth based on the figures previously established: 1.40% average S&P dividend yield plus 6.16% average earnings growth = 7.56%. For our estimate, we’ll assume the P/E drops from its current level of 27.9X to 24X, resulting in a return drag of -1.49% per year. Add that to 7.56% and you have an expected return of 6.07% per year for the next ten years. That’s quite a bit lower than 13.88% we just had for the ten years ending 2020.

Again, this is a forecast, not a guarantee. Investing is not a science, and measured ingredients do not yield identical, repeatable results. However, we do use a scientific approach to conduct research, analyze data and draw conclusions. If we view our portfolio as an experiment, we draw on our knowledge to create the hypothesis and minimize the variables to give us the best chance to achieve our desired outcome.

What to do about lower returns?

The market will give whatever the market gives. As stewards of our clients’ wealth, we make decisions designed to yield results that fall within a target range of outcomes, but there are no guarantees that the results will follow our models. That’s why when we integrate an investment portfolio into a financial plan, it’s crucial to monitor, adjust and rebalance it as we move along the client’s time horizon. Otherwise, we may end up not meeting our goals.

So, what if you’re counting on 10% per year, but only get 6%? Or worse, what if you need 10%, but only think you can get 6%? The answer is to focus on what you can control. You can control how much you save. Expect low returns, then save extra. You can control how aggressively you invest. Expect low returns, but dial up the risk to allow for the possibility of higher returns. You can control how much you spend. Expect low returns, and live on a little bit less.

By focusing on what we can control, we can adapt as necessary when the market throws us a curve ball. As investment managers, we make reasonable, informed forecasts; however, changing your behavior adds resiliency to your financial plan when the markets fluctuate. It’s all part of the process.

If you would like to discuss your asset allocation or the integration of your investment portfolio into your financial strategy, use the link below to schedule a free consultation with one of our fiduciary advisers.

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