My biggest fear in today's market

From banking to insurance, the financial system is grounded in historical stock returns. What if this time is different?

Investing is mostly an exercise in forecasting. As Warren Buffett has previously explained, Aesop coined the formula back in 600BC: ‘A bird in the hand is worth two in the bush'. To this day, investing is a matter of working out what you have to give up today, how much you're going to get in return, and when you're going to get it.

If investing has a fault line, it's that working out the latter part of the equation usually relies on assumptions based on what has happened in the past.

Over the past 30 years, Australian shares returned 10% a year. After adjusting for inflation of 3%, the stock market's ‘real' return was around 7%. The US market has produced an almost identical return despite its much longer history. Since 1918, US stocks returned 11%, or 7% after adjusting for inflation.

In fact, whether you're looking at the UK or New Zealand, Germany or Canada, almost every developed country with an old stock market and reliable data has delivered a long-term real return of 5–7%. It makes you wonder, then, whether 5–7% represents a permanent state for the future due to a mysterious force in the markets or human psychology.

This number is very special. Insurers use it for actuarial estimates. Pension funds use it for return expectations. Asset managers use it as a benchmark, and financial planners use it to recommend your super contributions and withdrawals. You name it, this 5–7% assumption for long-term real returns is deeply embedded in the financial system.

What's more, because real returns have gravitated towards this figure for the past 10, 50, or 100 years, it's hard to argue ‘this time is different'. For several generations, anyone who bet against this magic number has been wrong.

Cromwell risk

I don't have a perfect definition for it, but my biggest worry in today's market might be described as ‘Cromwell risk', to borrow a term from value investor Ben Inker. In 1650, Oliver Cromwell wrote to the General Assembly of the Church of Scotland: ‘I beseech you, in the bowels of Christ, think it possible that you may be mistaken.'

Statistician Dennis Lindley fleshed out the idea in the early 1990s, suggesting that when considering the odds of something, you should always ‘leave a little probability for the moon being made of green cheese; it can be as small as one in a million, but have it there since otherwise an army of astronauts returning with samples of the said cheese will leave you unmoved.'

I'm banking on ‘normal' long-term returns for my retirement, and I'm guessing you are too. But what if the past 100 years of stock returns have been the anomaly? What if over the next 50 years, stocks produce a real return of 3% instead of 5–7%?

It doesn't sound like a big difference, but it adds up over time: if you invest $10,000 a year at a 7% rate of return, it would grow to $1m over 30 years, providing a nice retirement income. At a 3% real return, the same amount invested each year would only grow to $500,000. In other words, half as many cocktails in retirement – or another 16 years of work to make up for the difference.

If you're young and real returns fall short of the historical trend, your retirement plan is in deep, deep fertilizer. And the above example was using a 3% real return – what if it's just 1%?

It isn't hard to dream up ways this could happen. Central banks could keep interest rates low for decades, encouraging asset valuations to remain high and yields low; or perhaps the world economy will slow down as the population ages and productivity growth declines. Who knows, inflation could skyrocket and the real return even swing negative.

I know, I know. 100 years of history says this won't happen if you stick to developed markets and stay diversified. But that's the point about Cromwell risk. All it takes is one astronaut to prove you wrong.   

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