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About personal finance, investments and markets.
January 11, 2016

Why the sudden correction and what returns can we expect?

2016 is off to a poor start: despite a blockbuster US jobs report on Friday, the US equity market index S&P 500 sinks 6% in the worst week in more than four years. Here we take a quick look what caused the precipitous decline and what future return expectations investors should use for their financial planning.

Why the sudden sell-off in early 2016?

If you read the press, it appears that worries about China and the Middle East were the catalysts for this sell-off. While the events there certainly play a key role and should not be underestimated, something bigger explains the increase in volatility. Since the onset of the financial crisis, the Fed’s unconventional monetary policy has suppressed volatility, encouraging market participants to hold more risk assets across equity and fixed income. But as the Fed removes its support, markets are now returning to more normal ups and downs. Volatility is making a comeback and we have to get used to it. Higher volatility is no reasons to exit the stock market, but investors ought to be more thoughtful in their asset allocation.

So rather a market „crisis“ than an economic crisis? Yes, the balance of the macro data from the past month continues to be positive. Sure, growth remains slow, but the balance of evidence suggests the odds of a recession in the US and Europe in 2016 remain low.

What should investors do now?

The impulse when the stock market falls hard for a few days is to do something. Our life savings are on the line, after all. But unless our goals have changed in the last few days, it probably does not make much sense to overhaul an investment strategy based on a blip of market activity.

Long-term investors have time to recover. We know many 60 year olds, who sold all their stocks in 2009 and are healthy enough to live to 100. They locked in their losses in 2009 and did not participate in the subsequent doubling of the stock market. They would be going on a lot more vacations now and be worrying less about their savings if they had held firm.

Returns are almost never average

Which investor hasn’t heard the following statements:

  • „The average long-term equity return is around 8%-12% per year“
  • „The average long-term bond return is around 3%-7% per year“?

While this is true, in most years, the returns are anything but average.  In the last 90 years, there were only 2 years (1926 and 1968) when both equities and bonds actually delivered average returns. In most years, returns from financial assets were far away from the averages.*

2015 Vanguard v3

What returns can we expect in 2016?

People want to think the stock market is like physics: something that works in clean, predictable ways, where I can measure something now and it will tell me with precision what will happen next. But stocks are not like physics. They are more like psychology – a field that works in strange, paradoxical, unpredictable and messy ways. To forecast the stock market in the short-term we have to forecast human emotions. But nobody can reliably do that.

What are the likey long-term returns based on today’s valuation?

This is the only useful question – and one that helps us put together a proper financial plan to help you reach your individual goals.

While we cannot predict short-term returns, there are various methods that help us estimate expected returns for the long-term. We hope you find this informative as you consider your long-term investing goals!

  • Government bonds: the 10-year yield for Japan is 0.2%, Germany 0.5%, Italy 1,6%, US 2.2%
  • Corporate bonds: for European corporate credit the expected returns are 2%-3%, for European High Yield bonds 3-4%.
  • Equities: the historical risk premium over government bonds for holding equities is between 3%-5%. If we add this to the current government bond yields, we get expected equity returns in the range of 4%-7% p.a. While this is less than what equity holders received in the past, it is probably in the right ballpark because we are now at above-average valuation levels, below average inflation and generally have a less favorable demographic tailwind than in the past. Let’s look at the European equity market as an example: here the dividend yield (Euro Stoxx 600) is currently 3.6% – that means that we only need price appreciation of 3.4% p.a. to reach 7% total return. Remember, 7% total return is nothing to sniff at. At 7%, your investments will double every ten years.

Whatever you decide to do with your portfolio, make sure you know YOUR time-frame. Do not follow anyone blindly. We can help you to build your own financial plan based on your own financial objectives and risk tolerance. Talk to us.

Sources:

Vanguard (US financial data), own estimates

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