What returns are you expecting from stocks and bonds over the next 7 years?

This is a question that GMO (one of the largest and most respected asset managers) attempts to answer on a quarterly basis.

Their most recent forecast was downright depressing: -2.2% per year from large-cap U.S. stocks and +1.9% per year from U.S. bonds. If correct, it would mean a 60/40 portfolio of U.S. stocks and bonds would generate a return of -0.6% per year over the next 7 years.

By comparison, GMO is expecting +3% per year from cash, implying that there is little to be gained today from taking risk.

Source: GMO.com. Note: Nominal Total Return derived from GMO’s real return and adding their inflation assumption of 2.2% per year.

What was GMO expecting 7 years ago?

Somewhat better returns: +2.7% per year from large-cap U.S. stocks and +2.8% per year from U.S. bonds.

Source: GMO.com. Note: Nominal Total Return derived from GMO’s real return and adding their inflation assumption of 2.5% per year.

What actually happened?

U.S. large-cap stocks returned +13.2% (10.5% above forecast) per year and U.S. bonds returned +2.5% per year (0.3% below forecast). A 60/40 portfolio of U.S. large-cap stocks and bonds returned 8.9% per year versus 2.7% expected.

What went wrong?

Built into GMO’s assumptions was a mean reversion in valuations and profit margins which were deemed to be elevated in June 2011. Instead of mean-reverting, valuations and profit margins would continue to expand over the subsequent 7 years.

Source: Shiller.

Takeaways

Forecasting is an extremely difficult game. GMO has some of the most highly compensated, brightest minds in the business crunching numbers to arrive at these projections. You can be sure that they spend hours upon hours debating the assumptions and methods used. They are trying very hard to get it right.

So when they said in 2011…

1. That U.S. small caps will return 0.1% per year and they actually returned 12.0% per year, that should tell you just how wide the “margin of error” can be in this business.
2. That equities ranged from “unattractive to very unattractive” and that the S&P 500 is “worth no more than 950,” that should tell you how hard valuation analysis can be (S&P 500 today: 2,794).
3. That “Emerging markets will outperform …  for the next seven years” and Emerging Markets return 0.7% per year versus 13.2% for U.S. large caps, that should tell you that trying hard is not enough in a discipline where randomness dominates outcomes.
4. That “risk avoidance looks like a good idea” and “Cash should be seen as a safe haven replete with important optionality” and cash returns 0.5% per year, that should tell how long “dry powder” can remain dry.

Where did GMO go wrong?

This assumption, contained in a January 2010 letter, may shed some light:

“In contrast to predicting the impossibly difficult real world, predicting market outcomes is relatively straightforward. Profit margins and P/E ratios always seem to pass through fair value if, and it’s a big if, you can just be patient enough. Normalcy is what we assume in our 7-year forecasts.”

If they blundered at all, it was in assuming “normalcy” and believing that “predicting market outcomes is relatively straightforward.” There is nothing “normal” about the distribution of investment returns and nothing straightforward about arriving at a specific return number (to one decimal place) over a 7-year period. There is a huge difference between valuation and timing, and the range of possible outcomes over a 7 year period, particularly within in equities, is enormous.

The good news for the average investor is that they don’t need to have an opinion on the next 7 years in order to invest today. In fact, most would be better off in simply saying “I don’t know” when asked which asset class will be the top performer. For if they have the humility to admit to those 3 simple words, they will be more inclined to build a diversified portfolio and stick with it over time. If they can do that and nothing else they will beat most of the forecasters and “world-class” investors by default and can spend the next 7 years worrying about the many more important things in life than investment returns.