High or low, boom or bust, the global economy changes temperature all the time. It is difficult, nigh on impossible, to predict what happens. Follow our guidance and weather all storms.
‘Expected’ returns on your investments are a little like the ‘expected’ weather in the UK. We have a growing wealth of data and common sense on which to build forecasts in both areas. Despite generalisations – such as it’s warm in the summer and cold in the winter – the year-to-year variation is high. Investors must not believe that expected returns, like the weather, are accurate.
Forecasting the investment weather
Come rain or shine…
August is when many exhausted, post-exam families pack their cars and head for places like Devon and Cornwall. Memories of days spent camping, surfing and playing cricket on the beach, expectations of sunny days shattered as the Atlantic gales blow and rain lashes on canvas, sunny beaches swapped for overcrowded cafes, with steamy windows.
Despite memories that summers are warm and sunny, nothing is certain. In fact, long runs of uncertain summer weather are the norm, not the exception. The last few weeks have seen wonderful weather, but we hark back to the summer of 1976. Forty-two years ago.
Forecasting markets is as difficult as forecasting the weather
Parallels exist when trying to forecast future market outcomes. If forecasts had a high degree of certainty, people would invest in the highest returning asset class.
It is this uncertainty that leads to high rewards for investors. Holding a five-year index-linked gilt to maturity has a certain outcome. The UK government will pay you back at maturity and protect your income and capital from inflation. Owning shares in a small unlisted biotech company, struggling with another funding round, is different.
We accept that summers are warmer than winters. Investments with wider ranges of outcomes (i.e. ‘riskier’ investments), are expected to have higher returns than lower risk investments with narrower ranges of outcomes. Most of the time this works out, but not always.
“Prediction is very difficult… especially if it’s about the future.”
Nobel Prize-winning physicist Niels Bohr
You can see the challenge that your Capital financial planner faces; establishing what your money means to you and your family, how hard these assets will need to work to meet your financial goals, the need to estimate the future returns for each asset class. This ‘expected’ return is a starting point to see how your financial plan works out. To think that the expected return is an accurate estimate of how your portfolio will grow is to miss the point. We will demonstrate this below.
We’re all going on a summer holiday…
It is holiday season, so let’s start by looking at the weather in Newquay, Cornwall for 1st August each year. We know that August should be warmer than January. If we had to describe an ‘average’ day it would be a few clouds, sunny, warm, a gentle breeze and dry. The diagram below helps to illustrate the wide variation from the common expectation.
Table 1: The weather in Newquay, Cornwall on 1st August, on average each year at 3pm
Cloud cover
Temperature
Other metrics
| Rain | Wind | Humidity |
|---|---|---|
| 22 mph (10th percentile) | Dry – 40% | |
| 1-in-4 chance of rain | 14 mph (average) | Comfortable – 40% |
| 6 mph (90th percentile) | Humid – 20% |
The average day is cool, cloudy and windy, with a lot of variation around the ‘average’ outcome.
Forecasting the investment weather – building asset class assumptions
When making estimates of future asset class returns, it is evident that there is no absolute certainty. Only reasonable, informed estimates that relate to the long term. Over these time periods, market valuation levels are less influential than historical long-term data.
‘We should humbly recognize the limits of our understanding. Realized returns are dominated by randomness, structural uncertainty, and rare events. Expected returns are unobservable, at best, estimated with noise.
Antti Ilmanen[1] – Ph.D., author and Principal at AQR
The figure below shows the approach to constructing asset class assumptions adopted by Capital. What it demonstrates is that they are not single point estimates of guaranteed returns; they are the exact opposite. An expected asset class return is the most likely outcome.
Figure 1: Making reasonable asset class assumptions
Whilst historical data is a starting point – with data in the UK going back to 1900 – it is insufficient to deliver a level of precision with any confidence.
The annual average after-inflation (real) equity return in the UK has been 7%. We can be 95% confident that the average annual equity return falls within the range of 3.3% to 10.5%, but no more precise than that.
The average temperature in Newquay is 650F on 1st August (at 3pm) based on data going back to 1980. Statistically, we can be 95% certain that the average falls within a range of 64o F to 66o F.[2]
Returns are distributed around the expected average
Let’s explore an example using an expected return of 1.5% p.a. above inflation for short-dated high-quality global bonds, and 4.5% p.a. above inflation for global developed market equities. You can see the expected attributes below.
[1] Expected Returns: An Investor’s Guide to Harvesting Market Rewards, by Antti Ilmanen, ISBN: 978-1-119-99072, John Wiley & Sons, NY: NY, February 2011.
[2] Based on confidence limit 95% ≈ 65o +/- 2 X (3o/) = 65o +/- 1
Figure 2: Expected after-inflation return distributions of short-dated bonds and global equities
You can see that the ‘expected’ return sits within a distribution of other possible returns. The range of these outcomes is wider for equities than for bonds. Summers are hotter than winters.
Building portfolio level expected returns
These assumptions are built into portfolio level expected returns. We also need to consider the diversification benefits of combining different asset classes.
This is a topic above and beyond the scope of this note. The figure below shows the return distribution of a sample portfolio containing 60% global equities and 40% short-dated bonds (as above).
Figure 3: Expected portfolio returns – 60% global equities and 40% short-dated bonds
It is evident that, like the weather in Cornwall, expected returns come with an average outcome that lacks certainty. A wide range of alternative outcomes could occur around this average. It is tempting to wonder why we bother. Like knowing that summers are hotter than winters, we know that equities should have higher returns than bonds because they are riskier. This risk-return relationship provides a useful framework for portfolio construction made of multiple asset classes.
Don’t get fixated on ‘expected’ returns
The message worth taking away from this note is not to get fixated on the precision of ‘expected’ returns. None exists. With any average, you have a 50% chance of getting higher and a 50% chance of getting lower . Anticipating ‘what happens if…’ is an important part of the planning process and ongoing discussions with your Capital financial planner.
It’s a good idea to pack a Gore-Tex® jacket when going on holiday (or investing ), as the sun doesn’t always shine even though it might be expected to do so in Cornwall in August. Happy holidays.
Risk warnings
This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily the firm and does not represent a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.
Past performance is not indicative of future results and no representation is made that the stated results will be replicated.
Errors and omissions excepted.
Other notes and risk warnings
This article is distributed for educational purposes and should not be considered investment advice or an offer of any product for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.
Past performance is not indicative of future results and no representation is made that the stated results will be replicated.
