Setting Expectations In The Absence Of Facts
Now that 2016 is nearly behind us, investors’ thoughts naturally turn to 2017. What return should I expect from my investments next year? The great difficulty in answering that question is that we have limited facts to guide us. Sure, there is a plethora of historical data, as well as economists and media pundits who are paid to give us their predictions. (Note that they get paid whether or not their predictions turn out to be anywhere close to reality). But there are no sources that can tell us what will actually happen with any degree of certainty.
In order to plan for our future we have to make predictions about it. But nowhere in the planning process are more questions raised than about future return expectations. New clients today invariably react to investment growth discussions with the complaint that their return ten years ago was higher. That may have been true, but what happened ten years ago has no particular bearing on what will happen during the next ten years. In the absence of any hard data, whatever number we come up with will be at best a guess. Therefore our challenge for planning purposes is to reach agreement on something we can all accept. Here are some of the approaches I have found to be most effective.
- Be conservative. The downside of assuming higher investment growth than what actually occurs could result in a shortfall later in your life when your ability to recover from financial mistakes is much more difficult. It’s safer to build a plan comprising more conservative expectations.
- Avoid over-reliance on historical data. Performance data on different investment asset classes from previous economic periods are easily accessible. But the statistical tools for projecting future results from this data are extremely limited. Even logically sound measures such as Bob Schiller’s CAPE ratio, which estimates future returns based on current market valuations, are helpful but not especially predictive.
- Use consensus but be selective. All financial planners have to estimate returns when helping clients plan for their futures. Canvassing expectations from multiple CFPs can help you get a sense of group thinking. But make sure to exclude those who are self-promoting. By that I mean all commission-based advisors, all economists who are paid by organizations that sell financial products, and all media personalities (whose primary goal is ratings, not education).
- Avoid confirmation bias. That’s our tendency to seek only information that reinforces our previously-held beliefs. Try to find sources with whom you disagree and try to understand how they’ve reached their conclusions. It will help balance your own expectations.
- Stress-test your assumptions. Do you validate the consequences of your investment expectations using different measures? For client retirement plans I always test against an average case scenario, a worst case scenario, and a statistical measure based on what is called Monte-Carlo analysis. The more stress tests you apply to your assumptions, the more comfortable you will feel with your projections.
Planning for the future is more of an art than a science. We do have tools that help make the results detailed and practical. But coming up with good assumptions, especially about the growth of your investments, is very hard to do. Spend the time it takes to build your own confidence in the results. Although you’ll be wrong more than you’ll be right, over time you may be surprised at how close reality will reflect your planning.