I have posted Entry #356 to my weekly Valuation-Informed Indexing column at the Value Walk site. It’s called Valuations Explain a Lot — But Not Everything.
Juicy Excerpt: The reality, of course, is that the 6.5 percent figure is not etched in stone. It could be that the U.S. economic system has become more productive than it has ever been before in recent decades and that on a going forward basis the long-term return will be 7.0 percent real. Or of course things could go the other way and the future long-term return could be 6.0 percent real.
Even that statement highlights the danger of ignoring valuations. If you don’t take valuations into consideration when determining the true value of your portfolio, you will be fooled into thinking that annual gains of 20 percent or 30 percent or 40 percent are real and thereby mess up your financial planning efforts in a serious way. Those who presume that the 6.5 percent long-term average return will continue to apply manage to avoid falling into the trap of believing that whatever numbers are generated by widespread irrational exuberance are real.
But the average long-term return really can change. The benefit of using the historical return as one’s assumption for the going-forward return is that it is an objectively generated rule of thumb. We all want to be able to retire as soon as possible. Left to our own devices, I suspect that a lot more of us would assume a going-forward return that is higher than 6.5 percent real than would assume a going-forward return that is lower than 6.5 percent real. Still, those who have strong beliefs that economic changes justify different assumptions are being entirely reasonable in using those assumptions in their asset-allocation decision-making process.