You can’t beat the market but the market is probably going to slap you around a bit.
That’s the upshot from hedge fund guru Ray Dalio, who thinks investing alpha, or outperformance, will be in short supply in coming years. What’s worse, he sees equity returns, sapped by years of QE, as only averaging about 4% a year for a decade, with no diminution in volatility.
It’s enough to turn an investor to another of Dalio’s interests: meditation.
Dalio, the founder of US$120bn hedge fund firm Bridgewater Associates, thinks the Fed is getting diminishing returns from its bond buying.
“It is working with a consistently decreasing effect and will work with even less effect,” he told a conference sponsored by The New York Times.
“The Fed is trapped … and will not be able to raise interest rates for a number of years.”
With asset prices already high, future returns will be lower and the benefit to the economy less and less. That may force the Fed to keep stimulating, but to less and less effect.
Perhaps the scariest part of this forecast is the idea that, while returns will be relatively low, equity risk, or volatility, will not go down. An asset class which remains highly volatile, like equities, but returns only 4% a year for a decade is a huge problem for investors.
Not only do they risk finding themselves short in a market downdraft, investors will be, inevitably, tempted to bail out.
That classic small investor move then opens you up to missing the rebound.
Dalio’s advice: spread your bets and don’t try to beat the market.
“Most investors are not going to be able to produce alpha – alpha is a zero sum. Most investors should create a balanced portfolio against that,” he said.
Dalio is probably right, but that doesn’t make the situation any better. Chasing outperformance is usually a losing game. However a market returning 8% to 10% a year is much more forgiving. If an investor spends 2.5% to 3% in fees making 10%, she’s still likely to beat inflation by a fair amount. Pay out 2% of 4%, or even 1% of 4%, and things look a lot more grim.
Living in a low return world
While creating a properly balanced portfolio is probably your best bet, the payoffs are not going to be high. And if that 4% a year return prediction comes true, you are also, almost certainly, going to have to rethink a lot of your assumptions.
Let’s say you, like a lot of pension funds, assume you can make 8% a year on a blended portfolio. Well you are only getting about 2% on bonds, so if you have a 60/40 equities-bond split you are going to come up massively short if your equities only return 4%. You need a 12% return to make your target. And don’t expect bonds to outperform – unless rates go massively negative there simply isn’t room.
So let’s pretend we are five years into the low-return decade and you stop to take stock of your retirement plans. If you have only made 2.5% a year for five years, the math is going to show you are way behind your target asset accumulation for retirement.
At that point you have essentially two options – neither pleasant and both with consequences.
Many will react by taking on more risk. They will cling to their high-return expectations and look for a charlatan who promises to spin gold from straw. Some will get lucky, make their target and think they are smart. Many more will squander more on fees and see lower returns. A few will meet with fraud.
More sensible people will simply save more, or lower their expectations for retirement. That’s a smart move, but one with unpleasant side effects. If many people all start saving more at once, economic growth will slow. The Fed, with all of its bullets already shot, will face another slowdown with no ammo.
Now central bankers are creative and resourceful, and so we might see some new tactic emerge to stimulate the economy. Then again, we might not.
That brings us back to mediation, which Dalio credits for much of his success.
So, close your eyes, empty your mind and breath deeply.
For 10 years or so, that may be all you’ve got.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at email@example.com)