Expected Risk

“The essence of investment management is the management of risks, not the management of returns.” -Benjamin Graham

Investors spend a lot of time trying to figure out what returns the markets will give them in the future. It feels like a weekly occurrence that I see another fund firm or well-known investor trot out their forecasts for future market performance.

People have been predicting lower future returns for a number of years now (the opposite has happened) so this is obviously easier said than done. I’m sure these people will be right eventually, but there are simply far too many variables to precisely predict future stock market returns.

The variable investors don’t spend enough time on is the one that’s much easier to predict — risk.

For example, people have been citing Robert Shiller’s cyclically adjusted price to earnings (CAPE) ratio since probably early-2010 or so to show how overvalued the stock market is. And you can see from the data that this would seem like a sound prediction.

Here I used Shiller’s data going back to 1926 to show the average three, five and ten year returns on the S&P 500 from different CAPE ratio ranges as the starting point:

screen-shot-2016-12-13-at-2-00-34-pm

There is a clear relationship between starting valuations and average future stock market performance. It looks obvious from this data that returns should be far lower from current CAPE levels (around 28) based on market history.

The problem is that averages typically lie to investors because they hide the risk — both to the upside and the downside. Here are those same starting CAPE valuations but now shown as ranges of best and worst three, five and ten year returns:

screen-shot-2016-12-13-at-2-00-23-pm

The same relationship applies as higher valuations have tended to lead to lower returns, but now you can get a sense of how far off actual can be from average. The spread between the best and worst returns has been huge over time. Trying to forecast future returns using this data with any precision is nearly impossible. On average this game looks easy, but in practice there is far too much upside and downside risk to account when making return predictions.

What you can use these valuation numbers for is to set realistic expectations. While there have been outlier returns from both high and low starting CAPE ratios, there is still a trend that exists within these numbers that should temper your expectations from current levels. You can see much higher highs and lows from lower starting valuations and lower highs and lows from higher starting valuations.

You can still get pretty good returns from high valuations starting points or poor returns from relatively low valuations, but the floors and ceilings are definitely different depending on the CAPE ratio range.

With a starting CAPE ratio of under 20 there was only a single ten year period that ended with negative returns (and just barely). There were no ten year periods that ended with negative returns from a starting CAPE of 15 or lower. However, almost 10% of all ten year periods with a starting CAPE of 20 to 25 saw negative 10 year returns while nearly 28% of periods were negative with a starting CAPE of 25 or higher.

(It’s also worth noting that a CAPE of below 10 or above 25 have only been seen roughly 25% of the time — split pretty evenly between the two — so both very high and very low valuations don’t have as large of a sample size to measure from.)

The probabilities are still in your favor as a long-term investors in these cases, but the potential for risk has been greater from higher valuation levels, which is where we currently stand. You should always plan for a wide range of outcomes in the markets, but this data can be useful as a way to better define those ranges (with the caveat that these ranges are by no means set in stone).

I also wanted to see how starting valuations would affect market volatility using these same numbers and was surprised with the results:

screen-shot-2016-12-13-at-2-00-29-pm

I actually expected this one to come out a little differently. I was expecting much higher volatility at higher valuations but that hasn’t necessarily been the case. Volatility has been fairly similar across all valuation ranges historically.

While these numbers were somewhat surprising to me, maybe they shouldn’t be. Volatility is a constant in the markets, whether it occurs to the upside or the downside.

Volatility is not a form of risk per se, but it can be if it causes unforced investor errors.

I wish I could tell people the exact stock market returns they will see in the coming years. The best I can do is tell people it’s a good idea to lower their expectations from what we’ve seen since 2009.

My only real forecast is that risk will be far easier to predict than returns because risk is ever present in the markets while returns are promised to no one.

Further Reading:
CAPE Fear of Lower Returns

 

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  • Gregory

    “I wish I could tell people the exact stock market returns they will see in the coming years.”
    I hope You can’t because it would remove the equity premium.

  • In my experience, people do not naturally think in terms of probabilities. They gravitate towards single point forecasts even when confidence levels are low. There must be a behavioral explanation for the phenomenon.

    Nick de Peyster
    http://undervaluedstocks.info/

  • LPL Advisor

    Forecasting in for fools… Shiller like so many academics have been consistently wrong in their predictions… Noise –

  • James Yaworski, CFA

    Ben you’re a smart guy and an excellent writer, I’m surprised to see that CAPE is even in your vocabulary. Given the changes in accounting rules, we know that the denominator in the CAPE calculation is no longer comparing apples to apples. A CAPE of 15 using today’s accounting rules would be significantly more attractive than a CAPE of 15 in say, the 1980s. Below I’ve attached Jeremy Siegel’s short white paper on the subject, I think you’ll find it interesting.

    http://www.cfapubs.org/doi/pdf/10.2469/faj.v72.n3.1

    In addition, CAPE is blind to inflation, which is a completely different issue.

    • Ben

      I’ve read the Siegel caveats and it makes complete sense to me. I’ve written about CAPE’s shortcomings in the past. See here:

      http://awealthofcommonsense.com/2015/06/cape-fear-of-lower-returns/
      http://awealthofcommonsense.com/2014/04/cape-ratio-range-historical-outcomes/

      People assume that valuations are timing tools, but they’re not. They aren’t signals or indicators. But they can help set reasonable expectations. And I would never use a single variable to make my decisions but I think it can be part of an entire toolbox or variables that can help gain perspective.

      • alain

        it is a gross filter, but it is a filter anyway… if you want to buy very cheap and dump very expensive, that is another help in the large toolbox of variables to be screened for proper valuation. I will print this article out and put it in your fantastic book as an addendum, so that I don’t forget this.

      • Stef

        Hi Ben, I am quite new to this but I read your positive review of Gary Antonacci’s book on Dual momentum. That technique does use a single simple variable to make buy/sell decisions. So how is that to be reconciled with what you say here ‘never using a single variable to make decisions’?

        • Ben

          Fair question. My take is that investors should not only diversify by asset class but also by strategy. So i don’t think many (any?) investors have the fortitude to stick w/something like a single risk factor such as momentum. I’m sure it would probably do just fine as long as you stuck with it but most people can’t. That’s why I think this strategy would probably work better behaviorally as part of a more diversified portfolio (assuming you’re comfortable with it) and not as a be-all, end-all.

  • breachoftrust

    Question for you Ben (about an unexpected risk that I need your unique perspective on).

    Oppenheimer calls it’s commission salespersons (brokers) “Financial Advisor”. I believe this is a misrepresentation under law and industry rules of misrepresentation (FINRA). This article mentions that there are 2,217 registered brokers at Oppenheimer. Oppenheimer has another category for something called a “Registered Investment Advisor”, which makes one wonder which category is the “actor” and which is the fiduciary professional. Confused? That is exactly as intended. see Dan Solin’s latest for source and article about this http://www.huffingtonpost.com/dan-solin/the-oppenheimer-way_b_13145102.html

    I bring a third perspective with which to view things, and the ‘Unexpected Risk’ I see in the mix is in this article: (I think the same ‘bait and switch’ happens by a few hundred thousand U.S. ‘brokers’) http://lethbridgeherald.com/news/lethbridge-news/2016/12/12/adviser-distinction-raises-alarm/

    I wonder Ben, if you bring any thoughts and ideas to the concept that truly registered (SEC and State) “Advisers” bring a fiduciary duty to care for the public, while few hundred thousand “brokers” act as ‘fake advisors’ to avoid informing the public that they are commission sellers without fiduciary duty. Thoughts from your end would be appreciated Ben. Thanks, keep up the good info please.

  • breachoftrust

    Question for you Ben (about an unexpected risk that I need your unique perspective on).

    Oppenheimer calls it’s commission salespersons (brokers) “Financial Advisor”. I believe this is a misrepresentation under law and industry rules of misrepresentation (FINRA). This article mentions that there are 2,217 registered brokers at Oppenheimer. Oppenheimer has another category for something called a “Registered Investment Advisor”, which makes one wonder which category is the “actor” and which is the fiduciary professional. Confused? That is exactly as intended. see Dan Solin’s latest for source and article about this

    http://www.huffingtonpost.com/dan-solin/the-oppenheimer-way_b_13145102.html

    I bring a third perspective with which to view things, and the ‘Unexpected Risk’ I see in the mix is in this article: (I think the same ‘bait and switch’ happens by a few hundred thousand U.S. ‘brokers’)

    http://lethbridgeherald.com/news/lethbridge-news/2016/12/12/adviser-distinction-raises-alarm/

    Ben, I wonder if you have any thoughts or perspective on the question of several hundred thousand FINRA brokers posing (acting) as if they were registered SEC “Advisers”? Thanks

    • Ben

      My sense is the entire advice industry is confusing for people outside of it

  • Flying Robot

    Ben, this article is a great example of the value of your blog. It’s sneaky smart. A simple discussion approached from an entirely different angle than you normally see. It serves as a great reminder about the inherent weaknesses in our thought process and the dangers of high level estimates when it comes to the markets. Probability is not a natural thought process. The stat I’ve taken has been immensely valuable for that very reason. When you put numbers on a page, it often leads to interesting insights, as your volatility summary has. It may be that volatility doesn’t increase at higher valuations, or it could be that valuations have shifted, as another poster mentioned. Either way, it points to productive areas of inquiry and should forestall some of the mental shortcuts we’re all tempted to apply to the markets.

  • Mobin Chowdhury

    Ben, can you also include the ranges for the volatilities for 3,5 and 10 years? As you state the averages can at times hide upside and downside dispersion.

    • Ben

      will take a look

  • Duocorn

    1. Real or nominal returns?
    2. Total return or just pct change in index level?
    3. Why that particular start year? Very different if you start in 1950 or 1970 for example (at least using nominal returns).

    • Ben

      nominal annual total returns. 1926 is as far back as I had the total returns on a monthly basis

  • J. Cross

    Your intuition that returns at high CAPE valuations should be more volatile is correct. Here’s why: volatility (standard deviation) is a measure of the dispersion of observations around a mean. Standard deviations (SDs) of different means are not directly comparable, although it’s done all the time in finance. For SDs to be comparable among means, they have to be standardized by the mean, this is, SDs are scaled to the mean of the sample. It’s an easy calculation: divide the SD by the mean. Multiply that by 100 and the result is expressed as a percent (this statistic is known as the coefficient of variation or CV). Using CVs, you can compare volatility between two means or among many means. Here are the CVs for your CAPE tables:

    CAPE…..3 YR…….5 YR…..10 YR
    5-10……..92%……..98%……114%
    10-15……103%….125%……115%
    15-20……254%…..211%……170%
    20-25……173%…..193%……311%
    25+……4,475%…2,757%…..454%

    When the means of two samples are close in value, the SD is a good approximation of the CV (look across the rows for different CAPE intervals). When the means are widely different, the SD is misleading (look down the columns).

    • Ben

      good stuff. thanks for running the numbers

  • Cameron Hight, CFA

    Great article. Simple analysis is so often the most profound.

    My only suggestion would be to look at your CAPE buckets differently. For instance, the 5-10 bucket is an earnings yield range of 10% to 20%, big range. The 20-25 bucket is a range from 4-5%. Those two buckets don’t seem comparable.

    The point is that 1 multiple point difference at 20 is not the same as 1 multiple point at 5. I think you might see even more delineation in your results if you make that change.