Using Stock Return Predictions

According to the Stock-Return Predictor, the most likely return of stocks will be 1.3% (plus inflation) ten years from now. Today’s TIPS yield 2.5% (plus inflation).

Does this mean that we should invest entirely in TIPS?

No. Not necessarily.

Remarks

The odds are about 60% that stocks will underperform TIPS over the next decade. The most likely real, annualized, total return is 1.3%. That is, 1.3% per year plus inflation. The 20% and 80% probability points are minus (1.7%) and plus 4.3%. The 5% and 95% probability points are minus (4.7%) and plus 7.3%.

Here are some things to keep in mind.

First, there is always a 10% chance of being blindsided. I assert that this 10% is ALWAYS true. For purposes of discussion, I mention this in terms of the Stock-Return Predictor.

Second, think about your emotions. This is what Rob Bennett specializes in. What would you do if stocks were to underperform at year 10, as calculated, if they doubled along the way, at year 6? How would you feel? Would you panic? Would you give up on the Stock-Return Predictor? Would you start buying shares at higher prices? Rob Bennett's solution is for you to have a minimal, but significant, stock allocation at all times. Benjamin Graham's number was 25%. Rob Bennett suggests 25% or 30%. With a 25% or 30% allocation, you probably wouldn't give up on stocks if they were to double by year 6. Most likely, you would be in good shape at year 10.

Third, you need to assess all five of the highlighted returns. You need to know the effect on you personally, as an individual, for each of the major outcomes. There is still a 40% chance of an upside. The highest return is 7.3% (plus inflation). There is only a 5% chance of exceeding it, but some people (not many) would take the chance. How about the second highest number? It is 4.3% (plus inflation). That's a pretty good return. The odds of hitting it are only 20%, but you have a chance. How about the most likely return, 1.3% (plus inflation)? You have a 50% chance of doing at least this well. It is less than you would make with today’s TIPS. But you would still be making money.

And what about the downside? The unlucky level is a 1.7% (real) loss per year. This is lousy, but it isn’t a disaster. It leaves you with 84% of your money (in terms of buying power) at year 10. The odds of doing worse are only 20%. Even with a total disaster (-4.7% per year), you end up with 61% of your money (in terms of buying power).

Fourth, consider alternative stock choices. The Stock-Return Predictor numbers are for the S&P500. Many of us believe that value strategies deliver a consistent advantage. Historically, this has been as much as 2% to 3%. Retirees are likely to notice the advantages of dividend-based strategies. They can meet their needs better by buying high dividend stocks from high quality companies, especially those that supply necessities.

Finally, the hurdle is high, but not impossibly high for experienced investors. You need to beat the most likely return of the S&P500 by 1.2% to beat today’s TIPS. This does not mean that you have to beat the S&P500 by 1.2%. If the S&P500 does well, you can underperform it and still end up ahead of today’s TIPS.

Have fun.

John Walter Russell
July 26, 2006