Can We Be Brutally Honest About Investment Returns? - MoneyBeat - WSJ - 0 views
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shared by Javier E on 20 Jan 18
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Pension funds have fantastical expectations of the market
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With U.S. stocks at all-time highs, it’s more important than ever that investors be brutally realistic about future returns.
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A new study by finance professors Aleksandar Andonov of Erasmus University Rotterdam and Joshua Rauh of Stanford University looks at expected returns among more than 230 public pension plans with more than $2.8 trillion in combined assets.
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For their portfolios, generally consisting of cash, U.S. and international bonds and stocks, real estate, hedge funds and private-equity or buyout funds, these pension plans report that they will earn an average of 7.6% annually over the long term. (That’s 4.8% after their estimates of inflation.) These funds often define “long term” as between 10 and 30 years.
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Based on how they divvy up their money, how much are these pension funds assuming specific assets will earn?
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They expect cash to return an average of 3.2% annually over the long run; bonds, 4.9%; such “real assets” as commodities and real estate, 7.7%; hedge funds, 6.9%; publicly traded stocks, 8.7%; private-equity funds, 10.3%.
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consider bonds. The simplest reliable indicator of how much you will earn from a portfolio of bonds in the future is their yield to maturity in the present. With 10-year Treasurys yielding 2.6% and investment-grade corporate bonds averaging under 3.7%, it would take a near-miracle today to get anything close to 4% out of a high-quality fixed-income portfolio.
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That’s below the U.S. average of 10.2% annually over the past 90 years. But stocks were far cheaper over most of that period than they are today, so their returns were naturally higher.
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stocks aren’t likely to earn more than an average of 5.9% annually over the long run from today’s lofty prices.
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Among those, the least implausible scenario is higher inflation. So the pension funds could hit their 8.7% stock return that way — but such a surge in the cost of living would crimp their bond returns. What they would gain on their stocks they would lose on their bonds.
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the new study of estimated returns finds that the older a pension fund’s holdings of private equity are, the more likely its officials are to extrapolate those returns — as if the good times of the early 2000s, when deals abounded and buyouts were cheaper, were still rolling.
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Why do expectations among pension plans run so high? Because they have to, the chief investment officer of a large public pension plan tells me. State laws guarantee generous retirement benefits for millions of current and former government employees. To appear as if they can meet those obligations, the pension plans have no choice but to set their expected returns higher than reality is likely to deliver.
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That’s the exact opposite of what the rest of us should do. Sooner or later, investors who build their expectations on hope rather than on arithmetic end up sorry.