How to view your retirement investments

Key Points

When considering retirement investments, it is essential to understand long-term historic returns for different asset classes. Although the past does not predict the future, historical returns are a valuable input for making decisions and devising investment strategies.

In today's investment world, it is reasonable to consider the following as distinct asset classes:

We do not have well-referenced data on the other asset classes, and so will have to make some assumptions about them that may or may not turn out to be correct. Historical data, however, support the hypothesis that equities are the only class to grow significantly in value after taxes and inflation over long periods of time. In addition, we can conclude that cash makes almost no return after taxes, and bonds make little as well.

BASICS OF ASSET ALLOCATION

Modern portfolio theory guides investment theory and practice and has two main tenets:

1. Owning a group of asset classes that do not move in same direction at the same time (that is, are poorly correlated) usually adds to long-term returns while reducing risk. Therefore, it is reasonable to have some asset classes in your portfolio that are not expected to move in lock step. Note that this is not always easy to do, because the correlation between movements of various asset classes changes over time. Still, most investment experts agree that portfolio diversification is wise.

2. To assemble the best uncorrelated group of assets, one must at least attempt to predict future returns. This second tenet often is misinterpreted by pundits. It has become common practice to use historical returns of various asset classes to predict their future behavior, a practice fraught with danger and error.

For example, using the past 30 years of bond returns (during perhaps the greatest bond bull market of all time, as long-term interest rates dropped from the high teens to below 4%) as a prediction of the next 30 years would be a mistake. Similarly, assuming that real estate would have the same return as in the past (during the rapid run-up in prices through 2006, for example) would have been an expensive error.

We can use various methods of valuation to decide whether any particular asset class is expensive, probably fairly valued, or historically cheap. A prudent method of picking asset classes appears to be avoiding expensive classes, favoring cheap asset classes, and diversifying widely into the rest.