Today we have updated our long term capital market assumptions. Please note that today's Blog post is mainly for our clients who geek out on this stuff like we do. Others can best forget reading on and enjoy the beautiful fall. With that out of the way, let's get on with it.
First, let's define what long term capital market assumptions are. For our purposes, long term capital markets assumptions are simply 10-15 forward looking projections for how we think the markets will perform. And by markets, we mean things like different US stock categories, international stock categories, various bond categories, and things like real estate and cash returns. So these assumptions are simply the expected future returns for various asset classes and the correlations among these asset classes. Correlation just means will the projected assets classes move up and down close to each other or will they move in more opposite directions. This tells us the projection for how each asset class may act like a diversifier versus each other asset class.
So you may be asking why is this important? Well, for those clients who have a financial plan (and remember, if you a ConciergeAdvice client, this is included in our services), these long term capital market assumptions are super important. These assumptions are used in our RightCapital software to project the future growth of your investment accounts. So as you can imagine, they are a key ingredient in projecting your future financial picture.
So each year, we update our outlook for the next 10-15 years and update the long term capital market assumptions accordingly. We then update RightCapital and the associated financial plans with this new outlook. So let's get into what we do and what has happened for this year's update.
Let's first take a step backwards. There is an on-going debate in our industry regarding what assumed investment returns should be used for financial planning purposes. The most commonly held process used by a majority of advisors is to use "historical" returns to project future returns in their client financial plan. This is the simplest methodology and results in fairly consistent assumptions from year to year as the historical averages change very little from year to year as you are only adding one year's worth of data to an existing data set of many years worth of historical returns. So this "smooths" out the long term capital market assumptions from year to year and results in stable financial plan projections from year to year. This is a plus.
However, the downside of this approach is that it does not take into account where you are starting from when projecting the returns for the next 10-15 year period. For example, say you are in a period of historically low interest rates and the Federal Reserve has stated a commitment to normalizing them and to a sequence of raising the Fed Funds rate over the next several years. Without getting into the nitty gritty, just believe us when we say that rising interest rates leads to falling bond prices. So what this means is that if this situation were to play out, in all likelihood, the bond market over the next 10-15 years could possibly have lower returns then historical averages would predict.
A second scenario that could play out could look like this. Imagine a bull market recovery that lasted for 11 years had just taken plan. Market pundits know recessions are inevitable and with an 11 year bull market, a recession and a market correction are just around the corner. If this was imminent, the 10-15 stock market performance estimate could also be less than the historical projection would show.
So with these two scenarios, one may predict that the next 10-15 years would have lower than historical returns for the stock and bond markets. This is what long term capital market assumptions hope to capture with their predictions. And for those astute readers, the two scenarios that I laid out above are exactly what is taking place today entered Q4 of 2018 and exactly why our long term capital market assumptions are lower then the historical returns.
So back to how we deal with the projected returns in our financial plans for our clients. We believe the most important thing with our financial plans is to have accurate projections for your plan to have the best chance at your plans being successful. If we were to use just historical return projections, it is quite possible that our plans would be too successful and you could run out of money to support your goals if future returns were lower than historical returns. So we use the long term capital market assumptions within our plan projections to better match what we expect to happen over the planning horizon.
So here is what we do. We assume that your plan will experience the long term capital market assumptions over the next 10-15 years, then the next 10-15 year period will see a "mean reversion" to the historical returns (more on that term next), and lastly, the next 10-15 years, you will experience historical returns. So what do we mean by mean reversion? Well mean simply means average and reversion just means to return to. So what we mean is that middle 10-15 year period, the projected returns will just slowly return to historical averages.
So to sum it up, our planning assumes the following:
- first 10-15 year period you will see your returns equal to the long term capital market assumptions
- next 10-15 year period your returns will move from the long term capital market assumptions to the historical returns
- next 10-15 years period your returns will be the historical returns
So this results in a 30-45 year planning horizon (which is the length of typical retirements) and the return over the entire time period is just the average of the long term capital market assumptions and the historical returns. So each year, we average the two numbers for each asset class and use these new projections in our RightCapital software to update your financial plan accordingly. We believe this allows us to update your plan projections to take into account what is happening today in all of the investment markets (from stocks to bonds, from US to foreign markets) to give you the most accurate and scientific projections possible.
If you made it this far into the article (which I bet many of you haven't), then you may want to actually see what these numbers and projections look like. You can see them here.
So we hope you enjoyed today's post and are assured that we are always doing our best with both managing your investments and managing your financial plan so you have the best chance at financial success.
Until next time...