Now that is a pretty presumptuous sounding headline, I admit. But don’t worry, I am not about to look into my crystal ball and prognosticate about exactly what market sectors will be the best-performers over the next twenty years. I can’t tell you that, nor can anyone. But a look back at history reveals some important truths about how to approach the management of your portfolio in the coming decades.

Moderate Your Expectations
The past couple of decades have been extraordinarily good for stock investors. And for many investors, its really all they know. From 1980-1999, the S&P 500 had an average annual gain of 17.7%! After the sobering impact of the bear market of 2000-2002, the general view of many investors now is that the past two decades were indeed an aberration and going forward a return of 10% or so a year — roughly the (very) long-term average — is more reasonable.

More reasonable, yes, but unfortunately, not very likely. After long periods of excess returns, the market does not merely return to its long-term average, but typically underperforms that average for long periods. The reason is valuations. Long periods of excess returns are invariably accompanied by P/Es that rise to excess as well. And excess P/Es lead to below average returns for the coming period.

The table at right, from an excellent study by Crestmont Research, is quite illuminating on this point. They calculated the returns of the S&P 500 over the 85 different 20-year periods from 1913-2003 and ranked them by deciles from the worst 10% of 20-year returns up to the best 10% of 20-year returns.

As highlighted, the two worst 20-year average periods — with average annual returns in low single digits — began with high valuations (P/Es of 18 and 19) and ended with low valuations (P/Es of 9). While the three best periods — with average annual returns over 10% — started with low valuations (10-12) and ended with high valuations (18-29).

The returns from the market over the past 20-years fall into that rarified best 10% of all time. Whereas, if we look out towards the next 20-years, we find that we are starting with a market P/E of around 20, which in the past has meant a period of low to mid-single digit returns.

Focus On What You Can Control
Regardless of whether my thesis is correct or not, we have no control over what the market will return over the next month — or the next 20 years. I’m sure we’ve all heard the quite reasonable advice: “Don’t worry about what you can’t control.” Yet, when it comes to investing, we spend more time worrying about where the market is headed than just about anything else!

It is probably too much to ask investors to stop worrying about the market, but the flip side to that piece of advice is perhaps more important, and that is to pay attention to what you can control. In investing there are three major things we can control: how much we invest (save); how we structure our investment portfolio; and our investment costs.

When the stock market is ripping along at 18% per year, investors can afford to be, for lack of a better word, sloppy. If you aren’t really saving enough each year, no big deal, the value of your portfolio is still growing nicely. If you’re not well diversified, that’s okay, you’ll still probably make nice gains. And if your portfolio is full of high-cost mutual funds, that are sapping your returns, well, you’ll barely notice.

But when the market is growing more along the lines of its long-term average of 10% those factors matter a lot more, and if as we expect, the next couple of decades feature returns that are perhaps half of that — they are critical. In short, they can spell the difference between reaching your financial goals or adjusting to a retirement lifestyle that is less than you planned for.

Save As Much As You Can, As Early As You Can
For most investors, the number one factor in their control is how much they save and invest. Savings is simply a function of what is left of our incomes after our expenses, so controlling spending is the key to maximizing savings. And that is a matter of discipline.

How much should you save? It depends of course on factors such as expected future spending, when will the money be needed, how the money will be invested, and how much is already saved. Nonetheless, the standard rule of thumb that most financial planners use is that you should save 10-15% of your gross income annually. The problem with that recommendation is that it assumes you start saving from your earliest working days — something few of us probably have done.

Another approach is to consider how much of your pre-retirement income you need when you retire. That figure also varies according to personal circumstances, but a general guide is somewhere between 60 and 70%.

The following table (admittedly somewhat complex, but well worth the time to understand) from T. Rowe Price for those who have 20 years left until retirement, shows the percentage of current income replaced in retirement depending on how much is already saved and how much is saved each year going forward.

For example, if you have already saved 5 times your current income, and save 15% of your income for the next 20 years, you can expect to replace 65% of income in retirement. Not bad.

20 Years Left Until Retirement

But, if you have only saved 3 times your income by now, saving 15% per year from here would only get you 47% of your current income in retirement.

Obviously, this example is full of assumptions about how much your salary increases, about how your portfolio is structured and what the markets return (including, by the way, a 10% annual return for stocks!). Whereas, each individual is different. However, it does at least give one a general idea of how important savings are to how much we end up with in retirement.

A Low Return Market Does Not Mean A No Opportunity Market
Even if the stock market averages a relatively low return over the next 20 years, that does not mean you will have to settle for that average. There are a number of different ways to outperform. First, while the average return may be low there will still be plenty of periods where returns are much higher, and much lower, where an active asset allocation approach to your portfolio can pay dividends. Since 1900, the Dow Jones Industrials have had annual gains of greater than 16%; or annual losses of more than 16% — half of the time!

Second, within the broad market there are often sub-sectors that fair much better, and others that perform much worse, than the market as a whole. Properly underweighting and overweighting these sub-sectors can make a material difference. For example, in 2004 the large-cap S&P 500 was up a nice 10.9% — but the small-cap Russell 2000 rose nearly twice as much gaining 18.3%.

Third, there is more out there to invest in besides conventional U.S. stocks and bonds. The investment universe available to investors today is far greater than ever before, and thanks to the creativity of the financial community, getting greater all the time. Today we have commodity-based funds, emerging market bond, stock and even money market funds!

Pay Attention To Expenses
In our analytical work we are always examining the factors that lead to long-term above average returns for mutual funds. Some factors clearly affect performance, but are not in statistical jargon “persistent.” In other words those factors might be here today and gone tomorrow. A manager’s stockpicking skills tends to be persistent, while market-timing skills are much less so. Another factor that is not surprisingly persistent is expenses. Low expense funds have a built-in and permanent advantage over high cost funds. That doesn’t mean that the lowest-cost funds will always win - or even on average win. A bad manager on a low cost fund will still be a bad manager. But in choosing a fund, expenses are a key variable. If two funds are similar in terms of their other attributes, and one is lower cost, it should be preferred — this is especially true in a low return environment where a small difference in cost could make a big difference in relative returns.

Make Sure You’ve Got The Right Manager For Your Money
Naturally, we think that at Kobren Insight Management we have the philosophy in place that should succeed in this environment: we build diversified portfolios with an eye towards value, we will dynamically shift the asset allocation based off relative growth/valuations considerations, we primarily use actively managed funds who also can adapt on the margin, we traffic in a larger investment universe than many peers including the use of unconventional investments, and we pay attention to expenses — all expenses.

But I encourage you to stay in contact with us through your personal Account Manager so that you fully understand our process and how we are investing your money. And just as important, stay in contact so that we can fully understand your own life situation, attitudes and needs (and how they may be changing), so that we can do the best possible job in managing your money.