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By Michael J. Wiener
Special to the Financial Independence Hub
Before I go any further, I want to be clear that this isn’t a case of me having a “smarter” portfolio where I’m actively trading to beat the market. I steer people to low-cost passive investing and that’s what I use myself. The main difference between me and other do-it-yourself (DIY) investors is the degree to which I’ve built most of the complexity of my portfolio into an elaborate spreadsheet that alerts me by email when I need to take some action. I’m happy to automate complexity in this way and let the spreadsheet tell me what to do. I can safely ignore my portfolio for months without worry.
Pay yourself first
Bortolotti says “‘Pay yourself first’ has become a cliché because it works.” “Sure, you could wait until the end of the month and then save whatever is left after paying all your expenses.” “People following this approach rarely wind up with any surplus cash.” “Make your savings a fixed expense, too, and you’ll be well on your way to meeting your investment goals. It’s impossible to overstate how important this is.”
This is excellent advice. I recommend it to my sons. My wife and I never followed it ourselves. From a young age we were used to only spending money on necessities. It’s taken us decades to get used to spending money more freely. During our working years, our savings rate bounced around, but it was rarely below 20%, and reached 80% for a while when the family income rose and the kids cost us less. This wasn’t a case of us scrimping or having a savings target. That’s just what was left after we bought what we needed and wanted.
Expected future returns
Vanguard research showed “that most of the techniques people employ to forecast future stock returns are utterly worthless.” “So don’t get clever when you’re trying to estimate stock returns in your own financial plan. That average over the very long term — about 5% above inflation — is a reasonable enough assumption.”
As a retiree, I find it wise to back off from the long term average of 5% and use 4%; I’d rather spend a little less starting now than be forced to spend a lot less in the future if stocks disappoint.
Bortolotti is right that P/E ratios have little predictive value. I made this point myself recently. However, long-term data show a consistent weak correlation between P/E levels and future stock returns. This effect is almost unmeasurable over a year, and is very weak over a decade. However, it builds over multiple decades. I model this effect by assuming that P/E levels will decline to a more normal level by the time I turn 100, and corporate earnings will grow at an average rate of 4% annually above inflation over that time. At the time of writing, this amounts to assuming stocks will return 2.6% above inflation over the rest of my investing life. The missing 1.4 percentage points comes from the assumed drop in P/E levels over the decades.
The difference between my assumption of 2.6% and Bortolotti’s 5% is substantial. It’s probably not important to those still a decade or more away from retirement; they have time to try to save more, work longer, or plan a more modest retirement. Current retirees are another matter. If they assume their stock allocation will beat inflation by 5%, high spending in early retirement could leave them with meagre later years.
Factor Investing
Investment research over the decades has shown that stocks with certain properties have outperformed. These properties are called “factors,” and this whole area is sometimes referred to as “smart beta.” Some well known factors are value (“stocks with low prices relative to their fundamentals”), small cap (small companies whose market capitalization is below some threshold), and momentum (“when stocks rise in price, they continue that trend for months before eventually settling back to earth”). Continue Reading…
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