In an age of stock market volatility, it's more important than ever to focus on what you can control.
Nearly all of us could benefit from three resolutions: to be more vigilant about the cost of investing, to stick more closely to an asset allocation plan and to rebalance regularly.
These three strategies are key to navigating your way safely through stormy market weather. Over the next few years, they will be more important than ever for the simple reason that returns are likely to disappoint.
GMO, a Boston-based money manager, regularly produces forecasts for the real – that is, after inflation – returns it expects from various types of investments over the next seven years. In its most recent update, it predicts that U.S. large-cap stocks will lose about 1.5 per cent a year of their value between now and 2021. It also says that most bonds, as well as cash, will erode your wealth during that period.
To be sure, GMO spots some areas of hope. It says emerging market stocks, for example, will produce real annual returns of about 3.7 per cent. Put it all together, though, and GMO's view is that a diversified portfolio of U.S. stocks and bonds is more likely than not to lose buying power over the next seven years.
GMO's track record at forecasting long-term trends has been exceptionally good, and it's not the only market watcher to be warning of disappointing returns ahead. Followers of the so-called Shiller P/E, which looks at the stock market in relation to its earnings over the previous 10 years, have also been proclaiming that the market is overvalued. Meanwhile, Pavilion Global Markets, a Montreal-based research firm, issued a report earlier this month predicting that U.S. equities will produce an annual real return of minus 0.3 per cent over the next seven years.
Of course, any forecast is about probabilities, not certainties, and a host of mutual fund companies will be happy to lecture you about the strong returns they see ahead. But the logic behind the more pessimistic forecasts seems strong. Stocks look expensive in relation to their earnings over the past few years and share prices ultimately rest on corporate profits that have swelled to occupy an unusually large proportion of the overall economy.
If valuations and profits revert to normal levels, we're in for a spell of stormy weather. This is not a call to rush out of the market right now, but it is a warning that we would be wise to maintain modest expectations for the next few years.
Fortunately, there are things you can do to bolster your likely returns.
One is to keep a close eye on how much it costs you to invest. For instance, while advisers can deliver valuable counsel, it's more important than ever to look at what you're getting in exchange for your fees.
Those fees are often invisible, because they're embedded in the management expenses levied by your mutual funds before they report fees. Nevertheless, they do extract a toll on your results – and that toll looms larger in an era of lower returns. Paying 1 to 2 per cent in fees every year eats up a substantial part of your potential profits, especially if you expect your portfolio to produce annual returns of less than 5 per cent before fees.
If you're willing to invest a little time in learning about investing, a portfolio of low-cost ETFs that index key markets is likely to boost your returns substantially simply by lowering your fees. (For more on this strategy, check out the Canadian Couch Potato site run by my old colleague Dan Bortolotti at Canadiancouchpotato.com)
But low-cost indexing can't do all the heavy lifting by itself. Two other strategies are also important: Maintaining a disciplined allocation to stocks and bonds, and rebalancing regularly to get back to your chosen asset mix.
Andrew Ang, a professor of finance at Columbia University, demonstrated the benefits of rebalancing in a 2012 study.
He found that simply maintaining a portfolio of 60-per-cent stocks and 40-per-cent bonds, and rebalancing once every three months, would have resulted in substantially better performance than either an all-stock or all-bond portfolio during periods of market volatility, such as 1926 to 1940 or 1990 to 2011.
For instance, between 1990 and 2011, a period marked by the dot-com bubble and the financial crisis, an investor would have enjoyed a 612-per-cent return with an all-bond portfolio, a 510-per-cent return with an all-stock portfolio, but a 641-per-cent return with the 60-40 portfolio.
Keeping your investing expenses to a minimum, sticking to an asset allocation and rebalancing regularly aren't sexy, but they are three keys to doing well no matter which way the market winds blow.