Brent Sheather: Deny, deny, deny

If you're caught doing wrong, deny, deny, deny. Photo / File

Mindful of the statute of limitations, I discussed some of the low points of a misspent youth with a policeman friend the other day. He said that the best policy, if you are every caught doing anything wrong, is "deny, deny, deny", and if that fails become a police informant. Good advice for criminals and, perhaps, financial advisors. Faced with the inevitable prospect of lower long term returns from bonds and sharemarkets some financial advisors seem to believe the best policy is to deny this reality and continue with business as usual.

Recently an authorised financial advisor was quoted publicly as saying that historic long term returns would continue. What's more he gave reasons for this view and today we will examine these one by one.

Before we do and continuing with the analogy to crime we should look for a motive for denying reality and this is pretty clear to see as far as the industry as a whole is concerned if not the adviser in question. The motive is fees any advisor who tells a client that returns from a balanced portfolio will be 7 per cent pre fees cannot at the same time present an investment recommendation with the industry average 3 per cent pa fee structure.

First up the advisor acknowledges that return assumptions are critical to any financial plan because, obviously, if they are too high someone saving for retirement won't have saved enough at retirement and, similarly, a retired individual will run out of money if they spend more than they assume they will earn.

All good stuff.

Where however the article gets into trouble is when the advisor says that it is difficult to predict the return on bonds and shares over the long term. The advisor makes another mistake when he says that the world's current economic problems are the reason why some people say returns will be lower in the future. For investors with a 20-30 year horizon these points are relevant but they really are a side show compared to valuation issues.

So why should we expect returns from shares be lower in the future? Well, for a start, there is the fact that just about every independent expert in the world is saying that's the case. And I am thinking here of Robert Arnott, Peter Bernstein, Clifford Asness, Warren Buffet, John Bogle, Dimson, Marsh and Staunton (DMS) of the Global Investment Returns Yearbook (GIRY), Jim Reid of Deutsche Bank and the Barclays Equity Gilt Study to name just a few.

Then of course there is the economic theory derived from the Gordon Growth Model. This model simply says that the future return on shares is equivalent to the dividend yield that you buy the shares at plus the growth in dividends that will occur in the future. Numerous studies have shown that growth in the long run is pretty constant at inflation plus 1 or GDP growth minus 1.

What has changed however is the starting dividend yield. Robert Arnott and Peter Bernstein writing in the Financial Analysts Journal state that the dividend yield from US stocks back in 1926 was 5.1 per cent.

Today the dividend yield is barely 3 per cent so that is one unimpeachable reason why returns on shares will be lower in the future. The other big reason is that in the last 100 years shares became more expensive and the simplest way of understanding that is to see that the dividend yield has dropped from 5.1 per cent to 2.5 per cent. In a landmark paper Arnott and Bernstein reckon that shares becoming more expensive has added 1.8 per cent pa to the historic growth of shares in the past.

This is highly unlikely to be repeated so now we have two reasons why future returns will be about 4 per cent pa less than those of the past. There are others but these are the main ones. In a touch of humour Cliff Asness wrote in 2000 stating that the stockmarket looked overvalued and thus future returns would be low however there was a chance he could be wrong but shareprices would have to go down a lot first!

Now let's look at future bond returns. Arnott says "as with stocks we prefer to take current yields as a fair estimate of future bond returns". All he is saying is that with the 10 year US bond yielding 1.7 per cent we can be pretty confident that "buy and hold" investors will receive a return of about 1.7 per cent pa.

For 30 year government bonds the current yield is 3.0 per cent pa and that in itself is a good forecast of what returns from bonds will be in the medium to long term. But what were 10 year bond yields in 1926? Arnott advises they were 3.7 per cent so historic returns have again benefited from a higher starting yield, a much higher average yield over the period and recently the benefit of bonds becoming more expensive.

In summary Arnott and Bernstein say : "Stock returns in the past have been extraordinary, largely as a result of important non recurring development. It is dangerous to shape future expectations based on these lofty historic returns". This is important because shares typically comprise half of investors portfolios.

What this advisor's view also highlights is the huge failing in training for financial advisors. How on earth can someone become qualified as an Authorised Financial Advisor, be oblivious to these facts, and rehearse the old nonsense that past returns will repeat.

This is a common theme in the financial advisory industry, indeed in another paper Arnott asks the obvious question why the finance sector never underestimates future returns. An extreme version of overestimation was published by Armstrong Jones about 20 years ago when they said that real, after fee returns, from a balanced portfolio were going to be 10 per cent pa. Ridiculous.

Clearly this issue suggests there is a huge hole in the training of financial advisors and that is not surprising either because any training provider who had a realistic view of returns in their course material would find there was no demand for their services from financial advisors with 2-3 per cent fee structure.

But, hold on, it gets worse.

Arnott's paper is available on the web but if you have the good sense to read it you don't get any Continuing Professional Development (CPD) credits. If however you attend a course promoting an Australian small cap share fund which alludes to an ability to produce 10 per cent pa returns in perpetuity the CPD credits come rolling in.

Go figure.