In his February newsletter, Rob Arnott, former editor of the Financial Analyst’s Journal and an asset manager in his own right, gives his take on future returns after “the lost decade.” Arnott is not particularly hopeful about the next decade in financial markets.
To recap, he writes: “much of the pain of the past 10 years was caused by an overreliance on the equity risk premium and the corrosive effect of capitalization weighting our equity holdings. Simply bypassing these two practices would have delivered respectable 7–8% annual returns.”
That’s hindsight, which sometimes can be rewarding – if one learns from mistakes. But foresight offers little such solace: “the outlook for the ubiquitous 60/40 blend remains bleak,” Arnott reports “Unfortunately, moving away from this standard mix to a broader toolkit of risk exposures is likely to be less profitable than it was in the past decade as yields from diversifiers like REITs, TIPS, and emerging market bonds are well below the levels of 10 years ago.”
So a fallow decade is not going to be followed by a fat decade, nor is mean-reversion of much help, since stocks are trading at premiums to their historical averages. To eke out returns, Arnott recommends risk budgeting – or perhaps better, dynamic risk budgeting — over policy portfolios.
“Too often asset allocation programs are governed by a relatively constant risk tolerance, say on par with a 60/40 stock/bond mix. This approach encourages swapping one risky asset class out for another (e.g., non-U.S. developed stocks for emerging markets stocks, REITs for U.S. stocks, etc.). But in the current environment, when all asset classes are rich, shouldn’t we consider a more conservative posture? This approach isn’t market timing but risk budgeting. We choose to take long-term risk when risk-bearing is likely to be rewarded, and a conservative, well-diversified posture when it is not.”
Conclusion: budget for a risky new world, with fewer rewards than the past.