Since the lows of 2009 the S&P 500 index is up nearly 120%. Before this rally there were those who had been talking about low stock market returns for years to come. With the stock market having rallied so far so quickly, the odds of lower returns going forward might even be higher now.
I want to take a look at how various average returns for the market might impact a typical person's retirement situation. I will use Monte Carlo analysis in our retirement planning application to run various scenarios where average stock market returns are low for the next 20 years and then revert to historical return levels after that.
Monte Carlo analysis is a statistical tool that runs hundreds or thousands of scenarios and gives a person the probability that he or she will never run out of money. It does this by looking at the historical volatility (standard deviation) of the person's investments as well as the correlation among those assets. We then plug in a reasonable assumed average total return for each investment, either based on history or based on the user's projection, and the Monte Carlo simulator will shock these returns every year, generating many scenarios and the probability of not running out of money.
In each scenario I will show how changing stock market returns impact a couple's probability of never running out of money. Let's start with my base case assumptions
In the base case, I found that this couple has an 80% chance of never running out of money in retirement. This is not a terrible situation, but remember this also depends upon U.S. stocks returning 7% per year and emerging market stocks returning 9% a year.
What I now want to show is what happens if stock market returns are depressed for the next 20 years and then revert back to our 7% and 9% levels for U.S. stocks and emerging market stocks. It is important to point out that what these scenarios will do is lower the mean return in the Monte Carlo simulations and then run hundreds of Monte Carlo scenarios around that mean to generate the probability that funds are never depleted. The results are presented below.
Probability Of Never Running Out Of Money
Stock Market Returns 2% Less For Next 20 Years
Stock Market Returns 3% Less For Next 20 Years
Stock Market Returns 4% Less For Next 20 Years
We can see that a lot depends on our return assumptions. I personally believe that the next 20 years will give us very slow economic growth and therefore lower stock market returns than we've seen in the past. I believe that we could easily see the scenario where the S&P 500 index returns only 4% or 5% per year for the next 20 years.
So if one believes that lower stock market returns are in our future, what can we do today? I have always promoted investing for retirement in dividend paying stocks with a history of consistent dividend growth, such as Johnson & Johnson (NYSE:JNJ), Procter & Gamble (NYSE:PG), Coca-Cola (NYSE:KO), Exxon (NYSE:XOM), Intel (NASDAQ:INTC) and Wal-Mart (NYSE:WMT). Not only have these companies shown they can weather recessions without cutting dividends, the volatility of their overall returns are lower because such a large portion of their return is due to dividends.
A lower volatility of returns means a higher probability of success when Monte Carlo analysis is run. I also assumed that these dividend payers would keep growing their dividends at their five year average growth rate. I assumed that economic growth would be 2% or less each year for the next 20 years, so to be more conservative I put out that these stocks will only have returns in the form of dividends. There will be no price growth.
If we replace the value stocks in this couple's portfolio today with the stocks above and we adjust the volatility to match these dividend payers' historical volatility of 12% we see that the probability of success is now at 75%. That is not too bad given the pessimistic scenario I have laid out for economic growth.
The go-go growth days for America's economy are likely over for a while. This does not bode well for many stock funds and indices, especially given the run they've had over the past three years. But that does not mean that all stocks will fare poorly. I believe dividend payers with a history of solid dividend growth and a history of weathering recessions are what should be owned today.
We also live in a world of change and nothing is static. Building a retirement plan is fraught with assumptions, even those that use Monte Carlo analysis. But we can give ourselves a more realistic look at how things might pan out of we use statistical tools such as Monte Carlo that give us a more dynamic view of how our plans might unfold.