Retirement and the Stock Market

[UCLAseetoK]

This question stems after listening to Robert Kiyosaki's Rich Dad CD audio collection.

He stresses in his CD that he finds it "risky" that the majority of middle class U.S. workers have retirements that are completely dependent on mutual funds (or various other equities) and thus are dependent on the performance of the stock market by the time they retire.

This may be a basic question, but it made me wonder about what is the underlying idea behind why we would expect the market to provide positive, and by positive I suppose I mean beyond the 5% you could get risk free in a savings account/cd/etc, returns for us in the "long-run" by the time most of us would retire? (probably 10-40 years for the people in this forum)

[PokerFox]

[ QUOTE ]
This question stems after listening to Robert Kiyosaki's Rich Dad CD audio collection.

He stresses in his CD that he finds it "risky" that the majority of middle class U.S. workers have retirements that are completely dependent on mutual funds (or various other equities) and thus are dependent on the performance of the stock market by the time they retire.

This may be a basic question, but it made me wonder about what is the underlying idea behind why we would expect the market to provide positive, and by positive I suppose I mean beyond the 5% you could get risk free in a savings account/cd/etc, returns for us in the "long-run" by the time most of us would retire? (probably 10-40 years for the people in this forum)

[/ QUOTE ]

It simply is because the stock market has provided positive long term yields across its entire history.

http://www.finfacts.ie/stockperf.htm

11% average annual return for nearly 80 years.

[Objectothis]

Stocks are riskier than bonds or cash and as such generally price in a higher expected return to compensate for the risk assumed. In the long run stocks provide that return. For a non stock market professional, with 10+ years until retirement, their best bet is a low-cost mutual fund such as those provided by Vanguard.

[gull]

That's an extremely good question. History is not the answer, but it does help us to characterize the future. Essentially, companies create value (earn money) and there's a risk premium from the uncertainty of those future earnings.

Here are some papers that answer it:
http://altruistfa.com/readingroomart...#EquityPremium

[UCLAseetoK]

[ QUOTE ]
That's an extremely good question. History is not the answer, but it does help us to characterize the future. Essentially, companies create value (earn money) and there's a risk premium from the uncertainty of those future earnings.

Here are some papers that answer it:
http://altruistfa.com/readingroomart...#EquityPremium

[/ QUOTE ]

Thank you for the link, I should probably read all responses before I start quoting the first one I see next time

[DcifrThs]

[ QUOTE ]
Stocks are riskier than bonds or cash and as such generally price in a higher expected return to compensate for the risk assumed. In the long run stocks provide that return. For a non stock market professional, with 10+ years until retirement, their best bet is a low-cost mutual fund such as those provided by Vanguard.

[/ QUOTE ]

i know it.

i sound like a broken record.

but i have to just break this falacy down until it is widely understood.

so again, sorry for being a broken record:

listen, risk and return are inexorably linked. return is DEFINED by risk. many major hedge funds allow investors to set a risk target. by that i mean that they can aim for 4% total annual volatility (measured by st.dev of realized returns...yea we know, not the best measure, but it is what everybody relates to), or they can aim at 18%, or 2%. if your information ratio (risk adjusted return for actively managed investments) is 1.0, then for every unit of risk you take, you generate 1 unit of return.

so a target 4% risk level will, in expectation, generate a 4% annual total gross return.

similarly, the MIX of your investments is either optimal or it isn't. the concept of moving more towards bonds or cash as you age is not optimal. what would be optimal is reducing your risk target of your passive portfolio.

you can aim at whatever you like, but ideally, you should have a well diversified portfolio that has a sharpe ratio of between .4-.6 depending how much money is invested, how much work you are willing to do, and how well you understand portfolio structuring (or can pay somebody to do it for you).

while you are y ounger, you can take that .4-.6 sharpe ratio and aim it at a risk targer of, say, 18%. that will give you a target gross total return of between 7.2 and 10.8% per year. then, as you age, you can keep the same mix of assets, but reduce the leverage and add cash to the allocations thus aiming your risk target at say 10% annual volatility which would give you between 4 and 6% annual gross total return.

your MIX of assets shouldn't change as you age. just your risk tolerance.

Barron

[captZEEbo]

[ QUOTE ]
[ QUOTE ]
Stocks are riskier than bonds or cash and as such generally price in a higher expected return to compensate for the risk assumed. In the long run stocks provide that return. For a non stock market professional, with 10+ years until retirement, their best bet is a low-cost mutual fund such as those provided by Vanguard.

[/ QUOTE ]

i know it.

i sound like a broken record.

but i have to just break this falacy down until it is widely understood.

so again, sorry for being a broken record:

listen, risk and return are inexorably linked. return is DEFINED by risk. many major hedge funds allow investors to set a risk target. by that i mean that they can aim for 4% total annual volatility (measured by st.dev of realized returns...yea we know, not the best measure, but it is what everybody relates to), or they can aim at 18%, or 2%. if your information ratio (risk adjusted return for actively managed investments) is 1.0, then for every unit of risk you take, you generate 1 unit of return.

so a target 4% risk level will, in expectation, generate a 4% annual total gross return.

similarly, the MIX of your investments is either optimal or it isn't. the concept of moving more towards bonds or cash as you age is not optimal. what would be optimal is reducing your risk target of your passive portfolio.

you can aim at whatever you like, but ideally, you should have a well diversified portfolio that has a sharpe ratio of between .4-.6 depending how much money is invested, how much work you are willing to do, and how well you understand portfolio structuring (or can pay somebody to do it for you).

while you are y ounger, you can take that .4-.6 sharpe ratio and aim it at a risk targer of, say, 18%. that will give you a target gross total return of between 7.2 and 10.8% per year. then, as you age, you can keep the same mix of assets, but reduce the leverage and add cash to the allocations thus aiming your risk target at say 10% annual volatility which would give you between 4 and 6% annual gross total return.

your MIX of assets shouldn't change as you age. just your risk tolerance.

Barron

[/ QUOTE ]interesting post! Could you go into detail or provide links/recommended reading for calculating the sharpe ratio of a fund or the overall sharpe ratio of your portfolio?

[DcifrThs]

[ QUOTE ]
[ QUOTE ]
[ QUOTE ]
Stocks are riskier than bonds or cash and as such generally price in a higher expected return to compensate for the risk assumed. In the long run stocks provide that return. For a non stock market professional, with 10+ years until retirement, their best bet is a low-cost mutual fund such as those provided by Vanguard.

[/ QUOTE ]

i know it.

i sound like a broken record.

but i have to just break this falacy down until it is widely understood.

so again, sorry for being a broken record:

listen, risk and return are inexorably linked. return is DEFINED by risk. many major hedge funds allow investors to set a risk target. by that i mean that they can aim for 4% total annual volatility (measured by st.dev of realized returns...yea we know, not the best measure, but it is what everybody relates to), or they can aim at 18%, or 2%. if your information ratio (risk adjusted return for actively managed investments) is 1.0, then for every unit of risk you take, you generate 1 unit of return.

so a target 4% risk level will, in expectation, generate a 4% annual total gross return.

similarly, the MIX of your investments is either optimal or it isn't. the concept of moving more towards bonds or cash as you age is not optimal. what would be optimal is reducing your risk target of your passive portfolio.

you can aim at whatever you like, but ideally, you should have a well diversified portfolio that has a sharpe ratio of between .4-.6 depending how much money is invested, how much work you are willing to do, and how well you understand portfolio structuring (or can pay somebody to do it for you).

while you are y ounger, you can take that .4-.6 sharpe ratio and aim it at a risk targer of, say, 18%. that will give you a target gross total return of between 7.2 and 10.8% per year. then, as you age, you can keep the same mix of assets, but reduce the leverage and add cash to the allocations thus aiming your risk target at say 10% annual volatility which would give you between 4 and 6% annual gross total return.

your MIX of assets shouldn't change as you age. just your risk tolerance.

Barron

[/ QUOTE ]interesting post! Could you go into detail or provide links/recommended reading for calculating the sharpe ratio of a fund or the overall sharpe ratio of your portfolio?

[/ QUOTE ]

the sharpe ratio calculations are pretty straightforward math:

Sharpe Ratio

the real key is getting the risk calculation right.

you have to take into account volatilities & correlations and when you do that, your output is highly dependent upon the assumptions.

simple mean-variance optimization doesn't do it. you need to do monte carlo optimization with ranges around your assumptions to get a more robust estimate of your sharpe ratio.

moving away from literal calculations, it is more important to think about where this number comes from, what determines its size, and how could things occur in the future that would alter it.

for instance, what is the absolute maximum expected sharpe ratio for any stock in the universe of investing? why?

what is limit of the expected sharpe ratio of a portfolio of stocks as the number of stocks grows to the total number of stocks out there? why?

these, and other similar, questions are how you should think about how this all ties together.

another thing that is basically a given is that asset classes have different returns because they require the holders to take varying degrees of risk.

but if you normalize the risk levels of all those asset classes (say 10%), the excess returns you find are all between 2% and 3% yielding sharpe ratios of between .2 and .3

that's because, in general, if one asset class was noticeably better at increasing the efficiency of your portfolio, then people would flock into it and thus decrease the expected future returns by driving the prices of that asset up (so the theory goes).

it doesn't play out like that in the market b/c you don't observe each asset class's sharpe ratio in real time.

right now, TIPS have a high expected sharpe ratio because there aren't as many people piling into them in the US as there are in the UK (where the expected future sharpe ratio is lower due to a law that states that every certain type of institution or endowment must match assets and liabilities. so in the UK, the real rates are pushed lower artificially, depressing expected future gains, thus reducing the overall sharpe ratio of that asset class).

being able to think fluidly about what a sharpe ratio is supposed to represent and what determines it makes it easier to think about portfolio construction.

hope this helps,
Barron

[UCLAseetoK]

[ QUOTE ]
[ QUOTE ]
This question stems after listening to Robert Kiyosaki's Rich Dad CD audio collection.

He stresses in his CD that he finds it "risky" that the majority of middle class U.S. workers have retirements that are completely dependent on mutual funds (or various other equities) and thus are dependent on the performance of the stock market by the time they retire.

This may be a basic question, but it made me wonder about what is the underlying idea behind why we would expect the market to provide positive, and by positive I suppose I mean beyond the 5% you could get risk free in a savings account/cd/etc, returns for us in the "long-run" by the time most of us would retire? (probably 10-40 years for the people in this forum)

[/ QUOTE ]

It simply is because the stock market has provided positive long term yields across its entire history.

http://www.finfacts.ie/stockperf.htm

11% average annual return for nearly 80 years.

[/ QUOTE ]

I am aware of this, but I wasn't satisfied with it. Probably because that common idea that past results do not guarantee future performance line that we've all come to know.

I was wondering if it would bring up some ideas like the strength of our economy or something.... unsure [img]/images/graemlins/confused.gif[/img]

[PokerFox]

[ QUOTE ]
[ QUOTE ]
[ QUOTE ]
This question stems after listening to Robert Kiyosaki's Rich Dad CD audio collection.

He stresses in his CD that he finds it "risky" that the majority of middle class U.S. workers have retirements that are completely dependent on mutual funds (or various other equities) and thus are dependent on the performance of the stock market by the time they retire.

This may be a basic question, but it made me wonder about what is the underlying idea behind why we would expect the market to provide positive, and by positive I suppose I mean beyond the 5% you could get risk free in a savings account/cd/etc, returns for us in the "long-run" by the time most of us would retire? (probably 10-40 years for the people in this forum)

[/ QUOTE ]

It simply is because the stock market has provided positive long term yields across its entire history.

http://www.finfacts.ie/stockperf.htm

11% average annual return for nearly 80 years.

[/ QUOTE ]

I am aware of this, but I wasn't satisfied with it. Probably because that common idea that past results do not guarantee future performance line that we've all come to know.


[/ QUOTE ]

OK, but here's the deal. Let's say you made that statement in 1927. Or 1940. Or 1965. Or 1970, or 1985, or 1995, or 2000. Everytime you'd say 'just because the stock market has done well in the past doesn't mean it will in the future!' But every time, the stock market has proved that wrong.

The fact remains it has passed through numerous and immense technological, economic, financial, social, and global changes for 8 decades and has continued to be profitable.