Stocks have fallen approximately 25% since the start of the year. Does this mean my retirement plans and other financial goals are in ruins?
When we are immersed in a world where the doubling rate of a virus infection is measured in a few days, it is tempting to be consumed only by the here and now. But whether you achieve a future goal depends on the value of your investments now and future expected returns. Certainly, if you needed to sell your investments this week and buy a retirement annuity then your income expectations would be lower. For everyone else, a longer perspective is warranted.
If you have done some retirement planning with us you may recall that we used expected returns in our projections that are lower than historic returns, in part reflecting the high current stock prices. Expected returns are the average returns from the stock market in the future. Now we have lower current prices, but we also have higher expected returns, as illustrated below.
For illustrative purposes only
For illustrative purposes only
You may wonder why, with all the bad news, future investment returns are higher. Consider buying an asset you know has a value of $1 million in 20 years. Your return on your investment is determined by the price you pay now: the lower the price, the higher your expected return.
We don’t know the long-term value of any particular company and you may be concerned that current events will not only impair future value but in some cases the company will run out of cash and not survive. A recent study[1] by RBC estimated that only 5% of a firm’s value is attributable to the next two years of its operation, meaning most of the long-term value is beyond immediate concerns. We also diversify across many companies, some of whom will disappear, but they will be replaced by new ones we have yet to imagine. Overall, the relationship between stock prices[2] and future expected returns holds.
Over the coming weeks and months, we will be revising client’s financial plans to include current portfolio values, which may be lower, but also higher expected returns for stocks. The net impact will depend on individual circumstances and the allocation to stocks in your portfolio. Younger clients will benefit more than older clients, but even those near, or in, retirement should remember that retirement is not a single event and performance of investments during retirement are a significant contributor to retirement income.
Another way of looking at this is when planning your goals, we have built in resiliency to the events you are currently experiencing. No-one likes short term wealth declines but for those who adopt a goal- based perspective there are long term compensations.
[1] RBC Global Asset Management (March,2020), Source: Credit Suisse Holt Database; 20,000 firms. Based on the average firm in the Credit Suisse Holt universe. Percent of firm value derived from the cash flow of a typical company from the Credit Suisse HOLT®universe with 25% working capital, asset life of 10 years, growth of 2.5% and CFROI®equal to its cost of capital at 6%. CFROI®is an approximation of the economic return, or an estimate of the average real internal rate of return, earned by a firm on the portfolio of projects that constitute its operating assets.
[2] Actually relative price, this paper provide a more detailed discussion.
