Stress-Test Your Plan
Key Take-aways:
– Stress-test your plan is a good way to see if you can ride through rough markets
– “Capital Market” outlooks from firms like Vanguard are NOT market timing tools. But they’re often misinterpreted as such
– These outlooks can serve as guides for intermediate-term planning (10-15 years) based on current valuations
– Long-term returns (20-30 years) tend to converge on historical averages – regardless of starting point
– Diversification is important: different market segments take turns outperforming – “different things take the baton at different times”
– When building financial plans, it’s better to use conservative return assumptions rather than higher-than-historical returns
– Both “capital market” outlooks and “historical returns” can be valuable to stress-test a financial plans
– Ongoing check-ins with a financial planner allow for real-time assessment (and adjustments) to maximize a plan’s potential
Stress-Test Your Plan – Timestamps:
00:00 Stress-Test Your Plan vs Capital Markets Outlook
01:03 Understanding “Capital Market” Outlooks
02:00 Role of Market Predictions in Financial Planning
03:33 Diversification and Portfolio Management
05:10 “Historical Returns” vs. “Market Assumptions”
07:28 The Importance of Long-Term Planning
13:38 Stress-test: Balancing Safety with Opportunity in your financial plan
Stress-Test Your Plan – Links
Catch all our Mullooly Asset videos here
Subscribe to the Mullooly Asset YouTube Channel
Watch this episode (Stress-Test Your Plan) on our YouTube Channel
Vanguard Capital Markets – Market Perspectives
Vanguard Capital Markets – press release with link to report
Stress-Test Your Plan – Transcript
All right. So I think we want to talk about a recent update that Vanguard did to their capital markets outlook. It got a fair bit of attention, maybe more so than obscure financial data like this normally would.
That’s because their prediction over the next 10 years is quite low for the anticipated returns on things like US large cap growth stocks. These are the most popular investment of the last few years and a big piece of everybody’s portfolios.
Rather than nitpick their methodology or say whether we agree or disagree, I thought it might be a good opportunity to talk about the differences between how we view capital market outlooks from shops like Vanguard. JPMorgan puts out one, pretty much every big investment bank, has their own take on this.
Let’s talk about how they’re often portrayed versus how a financial planner might actually use them in practice to stress-test.
Perhaps I’ll begin by saying explicitly what capital market outlooks are not. They’re not a market timing tool, even though the way you’ll have them reported from place to place is like this one. For instance, “Vanguard says US large cap growth stocks are going to return 4% over the next 10 years.”
Like, should you be selling that?
It’s like “should you reallocate your portfolio as a result of that?”
It’s not that…
Goldman did one too – that was like 3.5% at the end of 2024 or something like that…
They explicitly said that in the Vanguard they’re like this is not like, we asked people about that and they said “this is not meant to be like a decision making tool for you to automatically go and change your portfolio tomorrow” about this.
But for whatever reason we like to get this information and then turn it into like a market timing tool. So it isn’t that.
Maybe I’ll kick us off – like what it can be – is if you look at what Vanguard put out (and everybody reports in a similar format), it can be like a probabilistic guide to how the intermediate term future might look, based on valuations in the market.
So while you’re not timing the market, I think valuation based work – like this – can guide you over the intermediate term. And a planning horizon can mean like 10 to 15 years — as opposed to the long term, which is like 20 to 30 years. Because 20-30 year returns tend to just converge on the historical averages.
But we might look at something like this to guide something shorter term about the portfolio.
I don’t know. What do you guys think about this? And how does it factor into planning work that we do for clients?
The first thing I’ll say is, the these kind of reports almost become self-fulfilling prophecies. In the sense that it’s like, well, especially after what we saw the last few months in the market where, you know, as Brendan likes to say, “number go up.”
Things really did well, markets did well. People sometimes are just looking for an excuse to sell. Or an excuse to rebalance, or an excuse to just take some money off the table.
And so in the short run, these things almost become self-fulfilling prophecies. In the sense that people will use them as their stick.
I think for us, especially when talking about things like US large cap growth, and things that have worked recently, I think it’s easy to just assume that it can continue on forever. But we could (kind of) use this as a way to realize that that’s not going to be the case and kind of point towards owning a little bit of everything.
There’s going to be times where US large cap growth rocks for a handful of years – like it has – and then value could take over. Also, international stocks, small cap, midcap.
So for us, I think, when building a balanced portfolio, it’s important to remember there could be – over the intermediate term periods where the things that have worked recently – might not continue to be strength there and that we could see some transition.
It’s important to kind of, yeah, it’s kind of the inverse of what Vanguard suggested in this. If you look at the data for their expected returns going forward, you can pretty much take the reciprocal of that information and say “what’s done best most recently” and if you have a diversified portfolio.
The silver lining of their prediction, whether it comes true or not, about US large cap growth stocks, is that if you have other pieces of your portfolio, those are some of the areas that have higher anticipated returns. Because they haven’t done as well in the last few years.
Diversify, don’t just hop from one to the other.
That’s not what this is trying to tell you.
I think that, you know, as planners, when we’re building plans and retirement projections for people too; we try really hard not to fall into the trap of what’s done well for us lately. We want to avoid recency bias.
I think that one of the ways that we do this – these “capital market” assumptions are looking to the future and making educated guesses about what future returns are going to be. But another thing that we can look at is “historical returns” and look at what the market has done over basically we have about 80 years, 70, 80 years worth of solid market data.
We can look back and say, “if your plan works using lower investment returns, then, and historical averages say that we can expect to earn a couple percentage points more than that, then your plan looks like it’s in good shape.” (how we stress-test your plan)
But what we don’t want to do is assume high investment returns, or higher than historical averages, and say, “OK, your plan looks good because we’re going to earn 12% per year” or whatever. It also, we also have to account for surviving the short term in order to get those long term historical averages.
And if you think about it, in terms of standard deviations, it’s basically not to get too “statsy,” but two standard deviations outside of an average return means that we can expect returns to fall in that window (about) 95% of the time.
It depends on how you’re invested.
If you’re all US large cap growth, you’re 100% invested, the standard deviation is going to be something close to 20%. Your average return is (probably) going to be higher, but the volatility that you have to endure is going to be extremely wide.
If you get to something like a 50/50 (allocation), the average return is going to be less, but the standard deviation is going to be less. So the variability in returns is going to be less. It all depends on where you’re at – and what you need – from the plan, how much risk you need to take, how much risk you don’t need to take.
These are all things that we’re taking into account when we’re thinking through (your) retirement plans.
I think that there’s a trap in there – in the sense that when we talk about – or when anybody in the business talks about – “average returns.”
They say “over the next 10 years, the average return we expect is going to be this,” doesn’t mean that you’re going to live in that -3% to plus 3% range.
You can still have plus 20% (years) and minus 20% years.
Over 10 years though, the number may work out to fall in their range.
And if you ask people what they expected in that period of 2000 to 2009, where the S&P returned, the narrative is the S&P returned…
A lost year…
nothing… you know, a lost decade.
There were plenty of opportunities to see plus 20%. And minus 40% in that (period). So averages can sometimes be a little misleading.
I think the other thing about that time period is the other areas of the market that did well.
I think, you know, like emerging markets were hot during then. Small caps tend to do well. So again I think that just speaks to diversifying.
Different things take the baton at different times. We have to get a…
We have to put up one of the investment return quilts here, so folks can just see a sample of what we’re talking about.
Well, if we’re talking about diversifying and planning and portfolio construction, one line of view here, we have to make some assumptions about the future. So we’ve talked about historical returns, we’ve talked about things like Vanguard or JP Morgan or Goldman Sachs and their capital market assumptions.
There’s often a lot of discourse in the planning community, in terms of how financial planning tools will give you the ability to use both in a plan setting. So you can use
1. the historical returns,
2. you can use capital market assumptions from whatever shop gets their stuff
…onto the planning platform you’re using.
Then there’s oftentimes a third option: where the adviser can go in and just fill in whatever the heck they want.
Which I think is the worst of the three.
I think the amount of hubris needed, to think that you know better than the “historical returns” or the capital market teams at a shop like Vanguard or JP Morgan; is just unbelievable. But (so) setting that one aside – because I think it’s junk. So, which one is better?
Unfortunately I don’t like — it’s not to be wishy-washy; but I think it’s, I think you can use both to provide context to a plan.
Because as Casey was describing before, I think you can use conservative assumptions, based on history.
So like, you could reach the same set of assumptions by using low-end historical outcomes – like instead of using the average historical return – you could use the 25th percentile historical return to say, like, “if returns are just bad, this is what they might look like.” And (then) use that average return in the plan for all the asset classes you’re allocating to.
Or, you could use a “capital market” assumption – like this Vanguard one that kind of is negative on some pieces of a diversified portfolio, to see like, “all right, well, what if they’re right? Like, how do the returns project the look on our mix over whatever planning horizon you’re using?” to kind of stress-test the plan.
And yeah, I think both can be valuable. And it seems like a lot of people, a lot of advisors, will fall to one camp or the other would like to just input their own predictions kind of thing. Any thoughts on that, from our perspective?
I think in terms of just using one, pinpointing one set of numbers and taking that as gospel, I think it’s just setting yourself up for failure, so to speak. Just because if there was one set of numbers that told the tale and worked every single time, everybody would use that. And no one would even bother putting out their own information.
So I think taking multiple sources of information and kind of coming to your own conclusions – and using a blend of everything – is probably the safest bet to not overweight or underweight the importance of one or the other.
Because like I said, if there was one “end-all, be-all” answer, then everybody would use it all the time, and it would be easy.
We’re guessing I guess is whether it’s us or the capital markets team. I mean, there’s work that goes into it. They are not literally just chucking darts.
But like, we’re making educated guesses about the future – no matter who’s doing it.
And I think they’re more educated guesses when you have more sources of information to kind of use as your backdrop. I think the important thing is, we all want certainty, especially folks who are looking to retire or invest their money for whatever purpose.
They all want certainty, everyone wants to know what’s going to happen in the future.
Unfortunately, there’s no way for us to be able to know that.
So I think just both – whether we use capital markets or historical returns – I think they both tend to get us pointed in the right direction.
So, we’re directionally headed where we want to go. And I think that’s really the whole point of financial planning and retirement planning. It’s not necessarily being exact.
Some things we want to get exact. But the big picture is we just want to know we’re headed in the right direction. And that we’re gonna be OK on that path – or if we need to make changes. What changes do we have to make?
Without hijacking the conversation, I’m hopeful we can go back to something Brendan said right at the outset, about the “intermediate term being something like 10 to 15 years.”
We could have stopped the video right there, in my opinion.
Because I think for so many people, “intermediate term” is like May or June, right?
Do you want to just talk about that from a planning perspective?
What we see as long-term and intermediate term?
Well, yeah. And I totally get that people live their lives; and “one year” seems excruciating when we’re talking about a market downturn, or anything like that.
So I’m not suggesting that we all have these “100 year” time horizons.
I get that WE don’t.
But when you look at historical data for stock market returns in particular, I think the longer the time horizon, like when we get up to 20 or 30 years – no matter what your starting point was, the returns all converge on the historical averages.
However, if you’re investing for a shorter period of time than that; which everybody is to some degree, depending on what their goals are within the portfolio. The returns, the range of them, gets wider.
So, depending on your starting point, if you had a good one or a bad one, you could have had a high-end outcome versus a low-end outcome.
And so that variability is, I think, when people do capital market assumptions, they’re trying to talk more about like “right now” as a starting point, and looking over the 10 to 15 year window after (beyond) that.
If you’re going to invest for 30 years, you can chuck it out. Because it’s probably just going to look like the historical returns.
But if you’re concerned about that more intermediate term, you can maybe use this capital market assumption as guidance on that. And if the returns on that sort of a time horizon aren’t where you want them to be, then the way you get more certainty (or hedge that risk), is probably like seeing if your plan works (with) having more money in safer shorter term assets versus the long term ones that are not giving you the sort of returns that your plan requires.
Like if you’re going to use the information, I think that’s how you use a capital market assumption. As opposed to “Vanguard said US large have growth is bad, we need to sell, sell, sell, get out.
That’s not it. That isn’t it, yeah.
That’s usually how it’s portrayed!
But yeah, not important to separate the two. I think you can also use the two different kinds of returns contextually, within a plan. Because if you’ve got capital market assumptions that are giving you a slightly negative view on a large piece of the market, like you can use that, in terms of the lower returns it probably creates for a financial plan to stress-test.
And then you could compare that to the historical returns to say, “all right, well, even if the low returns are probable, what if we get a low-probability outcome – to the upside?” And things are good? And they just look like history, to then just look at like “how much room to the upside could there be?”
Because the balance – where I was trying to find in retirement plans – is obviously you want to be safe.
But once safety feels like it’s feasible, based on the inputs, then, like how much higher can you go? In terms of spending and lifestyle.
People aren’t looking to die with millions of dollars (in many cases, unless that’s their specific goal). So it’s like, yeah, we want to coach people to safety, to make sure that they don’t run out.
But also we want to coach them to NOT leaving opportunities behind, when they’re no longer here.
And I think you can use different sets of return assumptions to (kind of) highlight that in a plan. And that sort of context is the “good part” of return assumptions, as opposed to the “bad part,” in terms of how they’re often, I think, mis-portrayed by individuals. Or misused as a “market timing tool” or anything along those lines.
Well said.
I think this also speaks to the beauty of an ongoing nature of working with a financial planner. And doing ongoing check-ins and stuff like that. So you can assess in (pretty much) real time how the plan’s going; versus the latest set of projections that we did. And what does that mean in terms of the spending that you’re doing from the portfolio.
It just highlights tweaks that can be made along the way to either protect the safety or maximize your plan to the fullest.
