Financial Market Forecasts are Essential to good Financial Planning

McKinsey released a very good report last week discussing the high probability of lower returns in the future. The piece was, predictably, met with great ire from efficient market proponents saying that forecasts are stupid and that no one can accurately predict the future. But these critics are missing the very important point that one should conclude here:

not that we can correctly predict the future, but that we should establish realistic and high probability expectations for the future so we can plan appropriately.

When you hear someone say that future market returns might be lower you shouldn’t run out and sell all of your stocks and invest in a bunker. Good financial planners and advisers establish future return expectations so they can establish financial plans that have a high probability of success.  Bad financial planners say you can’t predict the future and then extrapolate backtested results into the future because they don’t have a reasonable forward looking model for the world.

In the last 10 years we’ve seen this failure play out in the pension space as the majority of big pensions have built in unrealistic expectations of future returns thanks to the bad estimates from the extrapolative expectations crowd.¹ This usually involved some sort of extrapolation of past expectations where the adviser constructed future return estimates based on little more than past results.  The result is a widespread pension problem where potential withdrawal rates aren’t likely to meet their needs because returns have been lower than many people expected.

The McKinsey piece put the long-term returns in a nice historical perspective and then constructed a very reasonable set of future return outcomes. The basic conclusion was – temper your expectations as the rolling 10%+ returns from a balanced portfolio experienced in the 1980’s & 1990’s are unlikely to be repeated.

This is equally important at the individual investor level. The investor who has unrealistic expectations of future returns will very likely end up with a portfolio that perpetually disappoints them leading to the likelihood of the many behavioral problems such as excessive activity, high taxes, high fees, etc.

But more importantly, the unrealistic expectations lead to unrealistic current savings rates and future withdrawal rates. A smart financial planner constructs a portfolio plan so they can meet a relatively safe future withdrawal rate in retirement. After all, if you don’t plan appropriately for what you need you might not have enough when you need it.  The academic literature on safe withdrawal rates has changed dramatically over time with the SDR slowly creeping lower, but if the world of the future is one of lower returns then you don’t want to find yourself in a personal version of the pension fund debacle all because you didn’t build a reasonable financial plan with realistic future assumptions.  If McKinsey is right then responsible financial advisers will emphasize three important realities:

1. Be realistic about your withdrawal rates. 8%+ returns that many pensions have expected are likely unrealistic. For most individuals the 3-4% rules are probably fine starting points.
2. Construct an appropriate plan, temper your expectations for future financial market returns and don’t chase returns where the grass looks greener.
3. Spend less, save more and invest the difference today so you can increase the odds of meeting your safe withdrawal rate needs.

And heck, if McKinsey is wrong then you’ll be going on many more vacations in your retirement and/or leaving something for the kids to live on. Being prudent with future return expectations in the current environment isn’t about crystal ball gazing.  It’s about prudent financial planning.

¹ – See, “The Pension Fund Rate of Return Fantasy“