- Low bond yields and high equity valuations suggest future market returns could be low, extending the time it will take for an investment to double in value.
- Facing this possibility, many investors have opted to take on more risk, opening themselves up to potential psychological and portfolio stress should volatility return to markets.
- Rather than throw caution to the wind, we suggest a balanced approach, seeking overlooked value opportunities while trying to minimize downside risk.
Remember when the Rule of 72 was practical? A saver in her forties today may have learned back in college in the mid-1990s that this shortcut estimates how long it will take an investment to double in value. The rule is to divide the number 72 by the rate of return, and the result is remarkably accurate1. For example, an investment compounding at an annual rate of 7% (the yield on the 10-year U.S. Treasury bond in April 1995) would roughly double over a period of 10 years (72/7 = just over 10 years). The math is easy and the idea even encouraging: work hard, save a healthy amount of your income and let the power of compounding do its magic.
How quaint it all seems now. Let’s be honest, most of us aren’t equipped to easily divide in our heads by 1.6% (the 10-year Treasury yield as of early February 2020). More importantly, the outlook for future returns generally seems low. The S&P 500® Index trades at more than 18x estimated earnings over the next 12 months, representing an earnings yield of about 5.5% (the inverse of the price-to-earnings ratio), essentially a post-dot-com era low. The timeframe for doubling your savings is increasingly stretched, to put it mildly. As the rate of return falls from 2% to 1%, the timeframe leaps from 36 to 72 years! We might all look with empathy upon Japanese and German savers and their even lower interest rate levels (their 10-year government bond yields are actually negative, but that’s another story).
Rule of 72: As Rates of Return Fall, the Timeframe for Doubling Rises Dramatically
Source: Perkins Investment Management. The curve is derived by dividing 72 by the rate of return (Y-axis). Years required to double an investment are shown on the X-axis.
A key question, perhaps the question, for investors today is how to position a portfolio for a likely low return environment in the future. For many, the answer seems to be to take more risk. Lengthening maturities, lowering credit quality, buying glamour stocks, increasing leverage: these are all common ways of seeking higher potential returns. And to be fair, these moves have generally worked. Eleven years into the bull market, most asset prices have moved higher. However, in our opinion, each of these “risk-on” investment choices brings with it greater vulnerability to losses should current trends reverse. Investors who choose all of the above may become overextended and risk significant psychological and portfolio stress should markets become more volatile again.
The timeframe for doubling your savings is increasingly stretched, to put it mildly. As the rate of return falls from 2% to 1%, the timeframe leaps from 36 to 72 years!”
Rather than throw caution to the wind, Perkins’ portfolio managers and analysts take a more balanced approach to today’s low prospective return environment. We accept the reality of high current valuations and aim to participate in any future gains. But we also acknowledge the growing risks. First, we model a downside scenario for each security under consideration. We work purposefully to be aware of and think carefully about the loss potential of an investment. As valuations have generally become more elevated, we’ve increased our emphasis on limiting absolute loss potential in our stock selection. Perhaps counterintuitively, we’re identifying market-lagging value cyclical stocks that appear to us to have limited downside risk given their well-capitalized balance sheets, reasonable competitive positions and cheap valuations. Included among these are U.S. regional banks, select industrials and global auto manufacturers.
Second, we’re willing to go off the beaten path in our search for value. As markets ratchet higher, it becomes more important to be creative in idea generation. Many of the most “obviously” attractive companies have been recognized as such by the bullish market. We encourage our analysts to “turn rocks,” as often there’s something interesting available to buy with an attractive reward-to-risk ratio if you keep an open mind. Examples in our portfolios today include niche U.S. materials and tech companies and cash-rich, highly insider-held Japanese small/mid-caps.
Finally, and perhaps most importantly, our response to the apparent low returns available today is to, in a sense, bide our time. At some point, savers should pause and ask themselves: If an investment is going to take nearly an eternity to double in value, and that’s assuming it works out at all, why bother? Despite markets reaching all-time highs, the harsh experience of past market cycles should not be forgotten. As history shows, the investment opportunity set tends to change over time, is occasionally extremely compelling and, in any case, usually offers higher forward rates of return than is the case today. We’re aiming to be positioned to capitalize the next time bargains are plentiful and building diversified portfolios with an eye toward downside risk to try to achieve this important objective.
Sometimes it is helpful to return to first principles. The basic point of investing is to compound returns: If you’re able to save a portion of your income, over time the power of compounding can do wonders for your portfolio. Whether the timeframe to double is short or long, keep risk in mind as you make your investment selections.
Thank you for your co-investment with Perkins Investment Management.
Chief Investment Officer,
1It’s less precise than the logarithmic equation that will produce an exact answer, but it’s easier to figure out in your head.