An average day for me consists of reading, with a few breaks to write about what I have been reading. I read everything -- 10-Qs, 10-Ks and other SEC filings, press releases and academic studies. If it has to do with the markets and making money in the markets I am going to read it. I read at least two physical newspapers every day and dozens more papers and business journals online. Reading gives me a huge edge and as Charlie Munger has pointed out, he doesn't know any successful people that do not read a lot. While I do not agree with everything I read, or even a majority of it, I still take the time to consider each viewpoint and consider all the information.
Yesterday, a fascinating, if somewhat frightening study from the McKinsey Global Institute (MGI) crossed my desk. It is a view of the next two decades for investors. The study is titled Diminishing Returns: Why Investors May Need to Lower Their Expectations. According to the study, exceptional business and economic conditions in the U.S. and Western Europe over the past 30 years have produced exceptional real returns for stocks, but the conditions that produced those returns are now abating and could result in declines in future stock and bond returns.
The MGI study produced two scenarios for U.S. stocks. Under the more pessimistic scenario, returns average about 4% or so per year, while the more optimistic outlook calls for returns of about 6.5% per year on average.
The chief drivers of returns, according to the report, have been the long decline in inflation and interest rates, productivity improvements, demographic changes that led to rapid growth from emerging nations, particularly China, and strong growth as a result of technology gains and tax decreases. All of these factors are now in the process of reversing and the firm concludes that returns going forward will be much lower.
Before we just dismiss this possibility out of hand as doom-and-gloom garbage stop to consider that we have heard this before from one of the best investors of our time. At the 2015 Daily Journal (DJCO) corporate meeting, Charlie Munger said, "In my lifetime, success in investing was easier. If you were rational and disciplined you had a tailwind of 10% per annum. Now, I doubt that the world will be able to get 10%, so it will be more difficult; and it is impossible if you are staying in big stocks."
This is a potentially huge problem for investors going forward. We have become used to those 10% average returns to build wealth and plan for eventual retirement. Consider that at the historical 10% rate an investor who has $100,000 and can save $1,000 a month for the next 20 years ends up with about $1.4 million. At the more optimistic outcome suggested by McKinsey that's just $848,000, and at the lower growth assumption it is just $590,000. Your choices become save more, reduce your lifestyle substantially in retirement or retire later.
Now consider that all the academic research indicates that thanks to over-paying and over-trading most individual investors are earning half of the long-term returns of the equity market. At half the study's more optimistic rate-of-return scenario, the account above only grows to $520,000 while the more pessimistic outlook leaves the investor with just $445,000. To have a ghost of a chance at building wealth and reaching their eventual goals individual investors are going to have to get more serious in their approach to the markets.
So, if McKinsey and Munger are correct, and I suspect they may well be, about future returns it will not be enough to buy the popular stocks and funds and capture some of the market's return. Individuals will need to find ways to exceed the rate of the return of the overall equity markets. Here we can draw on the wisdom of famed investor John Templeton who advised, "If you buy the same securities everyone else is buying, you will have the same results as everyone else. By definition, you can't outperform the market if you buy the market. And chances are if you buy what everyone is buying you will do so only after it is already overpriced." For this reason, we have to think differently than other investors and find ways to gain an edge that earns excess returns.
Munger provided part of the solution at the same Daily Journal meeting when he said, "The people who still have value in investing are people who are willing to work very diligently and intelligently in less efficient markets."
Tomorrow I will discuss some of the ways investors who face the potential of 20 years of lower returns can look to outperform the sluggish indexes.