Predicting Future Returns…Not!

By, Bob Peters || November 30, 2021

Before we dive into this topic let me remind you that I am not a financial advisor and I am not giving you investment advice.  Your specific situation is unique, and you should consult investing and tax professionals to give you specific advice.  Nobody can predict future returns.

Talking heads

Now let’s get into it.  Technology today has given us instantaneous access to information that is pushed at us 24/7.  When it comes to investing there are countless folks who make a living on giving you their opinion.  “Talking heads” on financial TV shows can give you their opinion as why XYZ stock is a buy or sell or why the stock market will be higher or lower.

When you cut through it all, I come back to one point:  Well educated investment professionals are compensated very well and yet approximately 80% of them do worse than a low-cost passive index fund over a long period of time.  So, when you hear investment prognostication on what stock to buy or why the market will go up or down keep this in mind.  Remember to tell yourself that Financial Security is achieved by Investing Wisely over 30-40 years, not speculating on the meme stock, crypto or other hot idea of the day.

Reversion to the mean is a powerful and proven concept

The Nobel Prize-winning economist, Robert Shiller has compiled and maintains a database of public companies starting in 1871 up to the present.  The table below highlights, for each decade, the Price Return excluding Dividends, Total Return including Dividends, the rate of Inflation and the Real Rate of Return adjusting for Inflation.

When looking at this data you will notice that the mean stock market return for each of these periods, adjusting for inflation, is 6.9%.  The high ten year return was 16.7% and the low was (3.4%).

Here are three takeaways:

Dividends Matter

Dividends matter …a lot. 51.1% of the Total Return was attributable to Dividends.  Dividends exemplify the ancient proverb, “A bird in the hand is worth two in the bush.” Said another way, it’s more valuable to have dollars today vs. waiting for some date in the future.  More time equals uncertainty.

Inflation eats away your wealth

Inflation eats away your wealth and lowers the purchasing power of your income.  While there are more sophisticated measurements of inflation, for simplicity sake, let’s say that the price of all goods and services went up by 3% over the course of 12 months.  If your paycheck increased by the exact amount your purchasing power would be unchanged.  This is a simplistic example becasue nobody buys every product and service and some go up more than others.  In reality, there is generally a lag in the rate of wage increases which means that your purchasing power declines.

Inflation acts as a tax and disproportionally hurts people with few or no appreciating assets.

Years where the price of assets exceeds the historical averages are often followed by years of below average prices and vice versa

Years (and a decade) that have above average returns are often followed by years (and a decade) of below average performance.

This is really important and is priceless knowledge for building your Financial Security.  When prices for your assets goes down, your human brain triggers the flight-or-fight function.  Instead of selling your Investing Wisely assets like your brain is naturally inclined to signal, you need to hang tight. If you are young and have the ability to increase your regular contribution you will very likely benefit from future years where prices increase.  Buy low.  The corollary to this is to avoid chasing the hot idea of the day. Reversion to the mean is a powerful and proven concept.  In both directions.

Note:  This works for a very diversified broad based ownership of many companies but does not hold true for an individual business.  To invest in the common stock of an individual business you would be well served to perform an intrinsic value analysis.  If you do not, you are speculating.

A business is a stream of cash flows

All businesses have one similar goal.  To generate enough sales of their products or services to offset all of the costs and expenses incurred and have cash flow left over.   So you can think about a business as a stream of cash flows.  For many young businesses or those that are growing very fast, it may take years before the revenues exceed expenses.  After all expenses are covered the remaining cash flow can be used for one of three things:

1) To replace worn out assets necessary to keep the business in operation (we’ll call that “maintenance capital expenditures”).  Examples of maintenance capital expenditures could include new equipment that replaces older equipment to support the same level of business, furniture and upgrades to computers and software.

2) To invest in the future growth of the company (we’ll call that “growth capital expenditures”).  Examples of growth capital expenditures might be new equipment necessary to support an increased level of business.  Expanding the amount of physical space needed to support future business growth.  In addition, some of that excess cash flow will be needed to support growth of accounts receivables and inventory.

3) To return cash to shareholders.  In fast growing companies, the amount of cash available after all expenses is often insufficient to cover both 1) and 2) above so shareholders may not have any cash flow allocated to them (in the form of dividends or share buybacks).  In more mature businesses, where the business generates more than enough cash flow to invest in 1) and 2) above the excess cash flow left over can be returned to shareholders.  In the end, the value of a business to shareholders is the sum of the discounted present value of all future cash flows.

The level of profitability of a business changes constantly and therefore the amount of cash flow available to shareholders changes.  While it may be possible to calculate the next twelve months of cash flow with reasonable accuracy, it becomes essentially a guessing game how much cash flow a business might generate ten years in the future.  Yet, despite the increased fog of predicting ten years in the future, this exercise is necessary to perform an intrinsic value analysis.

Businesses don’t last forever

Innovation, competition, public policy priorities, shareholder behavior and the quality of management individually or collectively can contribute to the rise and fall of businesses.  I’ve always found it fascinating to study businesses in many different industries but in the end nothing is forever.  The well-respected Wharton Business School professor, Jeremy Siegel, determined that only 25% of the original S&P 500 companies in March of 1957 existed at the end of 2003.  Over the course of 46 years, a whopping 75% of the original businesses in the first S&P 500 index did not survive.  This illustrates the difficulty in performing an intrinsic value analysis which requires you to make an assumption about all future cash flows.   Businesses don’t last forever.

It is intellectually challenging to dig deep to understand the risks and opportunities of businesses, but a high degree of humility is warranted for those that try.  For this reason, I believe it is best to own a low cost, diversified index fund.   You will own a few companies that will not survive but also companies like Google, Microsoft, Amazon, Apple and Costco.  Better a little bit of each of the winners and losers rather than my Bank of New England story.