The future of the stock market is not what it used to be

In fact, you should take less. In unforgiving markets, it’s harder to recover from mistakes. Over the past decade or more, stocks, bonds, real estate, and cryptocurrencies — just about every asset — have boomed. You’ve often been rewarded for reckless risk, and while you’ve been punished, rising markets have helped you recover quickly from your mistakes. It won’t last forever.

A global survey of nearly 300 professional investors by BofA Global Research found in March that the percentage of fund managers with above-average exposure to US equities rose 27 percentage points from February. It happened even as many of them say their cash holdings have increased slightly.

And fund managers’ trigger fingers are itching even more than usual, with 42% saying their investment horizon is three months or less, up from 26% the previous month.

Individual investors don’t seem to be doing well either.

“Alternatives” such as private equity, private debt, hedge funds and non-traded real estate have become so fashionable that investors are giving up the flexibility and low fees to buy them.

One of the most popular ways to invest in alternatives is through unlisted closed-end funds, portfolios of alternative assets registered with the Securities and Exchange Commission but not traded on an exchange.

Investors generally cannot withdraw their money on a daily basis, unlike traditional mutual funds or exchange-traded funds. Instead, they can only sell at predetermined times, often four times a year, sometimes only twice, or even whenever the fund manager allows it.

Holding out for years could help managers produce gains; meanwhile, it allows them to reap fat fees. Management fees often exceed 1.5% per year. These funds managed a total of $93.7 billion at the end of 2021, up from $54 billion in 2018, according to Patrick Newcomb, director of the Fuse Research Network in Needham, Mass.

The glory days for approaches like these are likely over, says Antti Ilmanen, investment strategist at AQR Capital Management in Greenwich, Connecticut. He is the author of a new book, “Investing Amid Low Expected Returns”.

Mr. Ilmanen’s volume is not a range reading; it is full of subtleties and complexities. But his message is clear and simple. With many assets still near historic highs, future returns are likely to be lower, Ilmanen says, across the board, for traded and non-traded investments.

Yes, I know: that’s what many market commentators have been saying for years. And the markets kept going up anyway. Isn’t that just more negativism?

No. High recent returns make you feel rich, which naturally leads you to extrapolate further gains. But you’re just borrowing them from the future. The higher your holdings are valued, the lower their return is likely to be.

To understand why, suppose you own a hypothetical bond. To keep things as simple as possible, imagine a simple $1,000 bond earning 3% per year for 10 years.

If you buy it for $1,000, the annual interest of $30 on this bond will earn you a return of 3%. If, however, you pay $1,200 for a bond with the same terms, your $30 interest earns you 2.5%.

The higher the price you pay, the lower the bond’s yield; there is no way around it.

Unlike a bond, a stock’s future income stream can increase. If it fails to meet expectations, the same general principle applies, with no assurance of recouping your initial investment at the end.

To make broad judgments about stock prices, Ilmanen uses a modified version of a measure developed by Yale University economist Robert Shiller. Ilmanen’s calculations indicate that U.S. stocks could return less than 3% a year, after inflation, for the next five years or more, among his lowest estimates on record. While you can’t use this data to tell exactly when stocks are overvalued, Ilmanen says, “the message is that the prospect of low expected returns should be taken seriously.”

What can investors do? Some suggestions are obvious.

Save more, spend less (especially on investment management fees).

Avoid chasing after illiquid assets, some of which, like private equity, are definitely no longer cheap relative to publicly traded stocks, according to Ilmanen’s research.

Look outside of the United States, where stocks are considerably cheaper.

Above all, don’t take bigger bets to try to catch up. Riskier assets, such as stocks and non-traded bonds, have seemed safe during the bull markets of the past decade. But they could offer “bad returns in bad times” that aren’t as fleeting as they were in early 2020, Ilmanen says.

“If we get higher returns [as interest rates go up]more valuations will be challenged,” he says. “If you take less risk now, not more, you can rock the big pitches when they come.”

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