How to invest for the next two decades

What are you expecting your stocks to return to you over the next 20 years? And based on your guess, what are you going to do with your money?

So what are YOU expecting?

I'm serious... what are you expecting your stocks to return to you over the next 20 years?

This question is enormously important... If you're expecting 20% a year, then your $100,000 today will turn into nearly $4 million dollars in 20 years. However, if you're expecting 5% a year, you'll have a total profit of $165,000. What a difference!

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So what's your answer? Stocks have returned double-digit average annual gains for the last quarter-century. So is that your guess? Double-digit percentage gains?

And then based on your guess, what are you going to do with your money?

These are the big questions, and will determine how you invest over the next 20 years. So how should investors tackle the next two decades? Here's what I learnt from Ed Easterling...

I just returned from vacation today, and in my mail stack was a new book from Ed Easterling, called Unexpected Returns. Ed and I have corresponded a bit. One thing that Ed said to me that hit home was: 'It's not easy to get rational messages to individual investors.'

At first, that sounds strange. But it's exactly right...

You are bombarded with investment advice every day. But it always comes with an agenda - your broker would never tell you to sell, for example, because then you might take your money from him and give it to another broker. As another example, CNBC and Money magazine are always optimistic about stocks, because all their advertisers and guests make more money when the stock market is going up.

So Ed wrote a book with a lot of rational ideas in it (god forbid). The first idea I thumbed to in the book is incredibly important. Everyone who buys stocks should know this. But NOBODY PAYS ATTENTION TO IT. Here it is:

Ed investigated 20-year periods in the stock market. And what he found was extremely important...

In plain English: If you bought when stocks were cheap, your 20-year return could easily be double-digit annual returns, like we saw for the two decades of the '80s and '90s. And if you buy when stocks are expensive - like now - you don't make any money in stocks.

The price-to-earnings ratio (P/E ratio) is what Ed used to define 'expensive' or 'cheap.' The worst 20-year returns started with an average stock market P/E of 19. And the best 20-year returns started with an average P/E of 10.

For reference, today's stock market P/E is 20. And back in 1981, the market's P/E was less than 10.

Ed divided the 20-year return results into 10 groups, based on returns. The lowest returns for the next 20 years came when stocks were expensive - when the P/E averaged 19 at the beginning of the period. And the best returns came when stocks were the cheapest.

The lower the P/E ratio when you buy, the more money you make over the next 20 years. So simply put, you don't want to pay too much up front. If you want to earn double-digit returns in the stock market, you need to buy when stocks are cheap. And right now, they're not.

In the book, talking about markets today, Ed says '...High P/E ratios, low dividend yields, and low inflation reflect an environment similar to the early stages of secular bear markets... The current financial conditions indicate either low or negative returns from stocks and bonds.'

Ouch... now those are some unexpected returns.

So Where to From Here? Time to Row, Not Sail

'During secular bull markets, the investment strategy of 'sailing' by buying and holding stocks and bonds can be very effective. During secular bear markets, the investment strategy of 'rowing' with absolute return strategies can be very effective.'

For the decades of the '80s and '90s, we had the wind at our backs when it came to investments. We invested by simply sailing downwind - no ocean skills required. Stocks and bonds were going up nearly year after year. All we had to do was put up our sail - all we had to do was get in the markets.

Now the wind is in our faces. Putting up a sail (buy and hold) with no other strategy will only push us in the wrong direction. Instead, Ed says, we've got to row.

With rowing: 'The progress of the boat occurs because of the action of the person doing the rowing. Similarly, in 'absolute return' investing, the progress and profits of the portfolio derive from the activities of the investment manager, rather than the broader market movements.'

It's time to row, as Ed says. You've got to be aware that stocks and bonds are expensive by historic standards. So you've got to be an active investor (a 'rower') instead of a passive investor (a 'sailor'). And you've got to pursue strategies that can work if the markets are stacked against you, as they are now.

I agree with Ed so far. But then his bias comes out...

Ed is in the hedge fund industry. So his preferred type of investment over the next 20 years is hedge funds.

I'll agree that hedge funds are appropriate for part of the portfolio of high-net-worth investors.

But as you know, I'm interested in several investments that are uncorrelated to the stock market, as well. I've been writing for years about timberland, commodities and gold coins, among other non-stock investments. Still, I like what he has to say.

Hope for the Best... But...

Remember when Ed said 'it's not easy to get rational messages to individual investors'? Ultimately, if you pay too much up front, you can't make big profits. And if you can buy cheap, you can make good money - over the course of the next two decades.

The rational message is: Chances are, you won't make much money in stocks over the next 20 years. Based on history as Ed notes, stocks could give a total return of 3.2% a year over the next 20 years. Yikes. That number will likely be off by a few percent in either direction. But are you ready for an annual total return on stocks of between 0% and 6% over the next 20 years?

You ought to be prepared for it. Hope for the best, but prepare for the worst.

Let's hope Ed is wrong. But make sure you plan your investments (and spread them outside of stocks), just in case he's right!

By Dr. Steve Sjuggerud