To earn decent investment returns in the future, you’re going to have to diversify out of equities. The Philosophical Economist is back with a long article going into great detail to explain why most pension funds aren’t going to be able to achieve the 7.5% annual investment return that’s baked into their actuarial assumptions. Keep in mind this is a 10-year hypothesis. It doesn’t discount the possibility that decent returns will continue for another year or two. While most U.S. investors still are focused on U.S. stocks and the returns they’ve had since 2008, it’s better to diversify your portfolio and prepare for a different investment future.
The problem, of course, is that the people who are voicing concerns about valuation today are essentially the same people who were voicing them several years ago, when equity prices were half their current values. And they’re using the same “mean-reversion” arguments to do it, even though the market has persistently shown that it has no inclination to revert back to the valuation averages of any prior era. They overstated their case then, and so people assume that they’re overstating their case now, even though their underlying warnings may now be worth heeding.
In what follows, I’m going to explain why I believe long-term future U.S. equity returns are almost guaranteed to fall substantially short of the 7.5% pension fund target. Unlike other naysayers, however, I’m going to be careful not to overstate my case. I’m going to acknowledge the uncertainty inherent in equity return forecasting, and manage that uncertainty by being maximally conservative in my premises, granting every optimistic assumption that a bullish investor could reasonably request. Even if every such assumption is granted, an expected 7.5% return will still be out of reach.