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What should you expect from the market?

This post was originally published on this site

When we’re faced with the task of financial planning, one of the hard parts is projecting a reasonably probable future return for our investments.

We have tons of information about the past, but we can’t know the future. So what can we count on, anyway?

Like lots of other things in life, the future of investment returns must remain somewhat a mystery.

Still, I believe the past contains valuable lessons of what’s reasonable to expect. The world’s climate may be evolving, but you still know that at least for the foreseeable future, the tropics will be hotter than Northern Canada and that summer will be warmer than winter.

Similarly, if you think about the people you know, really good souls are likely to remain so, and jerks are not likely to quickly become nice people.

These things let us plan our lives around probability instead of leaving our comfort and our friendships entirely to chance.

Likewise, I believe some long-established investment patterns are likely to persist, for the same reasons they have persisted so far.

I believe investors can use these patterns to significantly improve their returns, without taking much additional risk or straying far beyond their current comfort levels.

Small changes…think of the trim tab on the rudder of a ship…can produce big results. Without getting into the mechanics of trim tabs, which are used in aircraft and boats of all sizes, I want to quote Buckminister Fuller from an article he wrote in the February 1972 issue of Playboy magazine.

“Think of the Queen Mary—the whole ship goes by and then comes the rudder. And there’s a tiny thing at the edge of the rudder called a trim tab.

“It’s a miniature rudder. Just moving the little trim tab builds a low pressure that pulls the rudder around. Takes almost no effort at all.”

Fuller used the metaphor to argue that just one person can make a huge difference by being a trim tab. I’ll use the trim tab metaphor to argue that even a small change in investment return can make a huge difference over a lifetime.

Imagine this simple scenario: Starting at age 25, you and your twin sister each invest $5,000 and continue doing so once a year for 40 years. Your out-of-pocket savings total $200,000 apiece.

When you’re 65, you each start withdrawing 4% of your portfolio value at the start of each year, and you continue that for 30 years.

Now imagine that you achieve a compound return of 8% a year up to age 65 and a return of 6% after that. Your sister, however, has a pre-65 return of 8.5% and an after-65 return of 6.5%.

The difference is a “mere” one-half of 1%. In any given year, you and your sister would barely notice the difference.

But on your joint 65th birthday, you would have $1.4 million and your sister $1.6 million. Hmmm. That difference is equal to the total of all the money each of you put into your savings.

And that’s just the start of it.

Over the next 30 years, your total withdrawals (your retirement income from this modest $5,000 yearly investment) will be $2.2 million. She, on the other hand, will take out $2.7 million.

When you celebrate your joint 95th birthday together, your portfolio will be worth about $2.4 million; hers will be worth about $3.1 million.

I’ve rounded some of these numbers, but the bottom line is this: Her extra one-half-of-one-percent return…which seems like a “trim tab” on a portfolio…brought her a total of about $1.27 million more than you got.

So the question is: how can an investor get an extra half-percentage point return?

I can’t tell you what will be true in the future, but here are some figures from stock indexes, based on returns over the 20 calendar years that ended in December 2018:

•The Russell 1000 Value Index earned 6.2%; the Russell 1000 Growth Index earned 5.1%.

•The Russell 2000 Value Index earned 8.2%, vs. 6.1% for the Russell 2000 Growth Index.

•The DFA Large-Cap Value Index earned 7.3%, vs. 6.5% for the DFA Large-Cap Growth Index.

•The DFA Small-Cap Value Index earned 11.3%, vs. 9.3% for the DFA Small-Cap Growth Index.

•The DFA Emerging Markets Value Index earned 13%, vs. 10.9% for the DFA Emerging Markets Growth Index.

•The DFA International Large-Cap Value Index earned 6.3%, vs. 4.5% for the DFA International Large-Cap Growth Index.

•The DFA International Small-Cap Value Index earned 10.1%, vs. 7.8% for the DFA Small-Cap Growth Index.

It doesn’t take the brains of Buckminister Fuller to see a couple of patterns in those numbers. Time after time, value outperformed growth. And in category after category, small-cap outperformed large-cap.

These are facts, but the question is what to do with them. I have a few thoughts on this.

First, I think we should believe in the premiums from smaller companies and from value companies. This 20-year period is not an outlier. The same patterns emerge time after time when researchers track comparative returns over the past 90 years.

Second, I don’t think we should bet our entire futures on these patterns. It would be a big mistake to invest exclusively in smaller companies and value companies.

But if you’re looking for a trim tab to earn an extra 0.5% a year, you could do a lot worse than to nudge your portfolio in the direction of value stocks and small-cap stocks.

This is exactly what I have done for many years in the Ultimate Buy and Hold Portfolio.

•In order to nudge toward small-cap stocks, I recommend investing in an equal mix of small-cap funds and blend funds, those that invest in both large and small.

•In order to nudge toward value stocks, I recommend investing in an equal mix of value funds and blend funds, those that invest in both growth and value.

I have carefully studied the results of this approach and found that it adds very little extra risk, but very significant extra returns, to a stock portfolio.

I can’t tell you the returns of the future. But I am quite certain that small-cap funds and value funds will continue to help investors earn better returns.

For more on projecting future returns, check my latest podcast, “Performance: What should you plan on for the future?”

Richard Buck contributed to this article.