Tales of the unexpected

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All investors know that risk and return are related – taking on more (sensible) risk should provide higher returns, over time.  Yet there are no guarantees. 

Advisers will often talk about target or expected returns from portfolios needed to deliver the financial goals of the client, but these forward looking assumptions are best based on a horizon of 20 years or more. 

Trying to make short-term guesstimates of market returns in the next year or two would be speculation.  Statistically speaking, the ‘expected’ return is the average of possible returns weighted by their likelihood of occurring, not the only outcome that may occur. 

At its simplest, the expected return of an investor’s portfolio is the sum of the expected returns of each asset class in the portfolio weighted by the allocation made to it.  It is not any form of promise or guarantee that this level of return will be delivered consistently, year in, year out.  The one certainty in investing is the uncertainty of short-term market returns. 

The hard part is deciding what those long-term returns are likely to be - and no crystal balls exist to see into the future.  In fact, it is the uncertain outcome that investors face that delivers higher returns.  So although any assumptions can only be approximations, they can still be reasonable and useful when based on sound analysis. 

Fortunately, investors can look at data for developed market equities, bonds and cash right back to 1900 - more than 100 years' worth of insight into both the long-term returns and interim uncertainty of being an owner of companies or as a lender.  The long-run real returns for bonds and equities are around 2% and 5% respectively (source: Credit Suisse Global Investment Returns Yearbook 2015), yet over the past 15 years, equities have done poorly and bonds exceptionally well, compared to their long-run averages; which only goes to show that extrapolating short-term data is naïve at best.

Using rules of thumb estimates for future equity returns

A commonly used rule of thumb for equity returns works on the basis that the return from equities is made up of the expected returns of enterprise (dividends received and the long-term real growth in earnings) and speculation (the change in the price that investors are willing to pay for each £1 of earnings, reflected in the price-to-earning or P/E ratio).  In the very long-term, market returns must equal the returns of enterprise. 

Real return = [Current dividend yield] [Real growth in earnings] /- [Change in P/E]

Given a dividend yield of 2-3% and long-term real growth in earnings of around 2-3%, a real return in the region of 5% is not unreasonable for developed market equity.   Financial planning decisions made on assumptions materially higher than this should be viewed with a high degree of caution.  Value and smaller companies, as well as emerging markets have expected returns perhaps 1% to 2% higher than broad developed equity markets, raising expected returns at a portfolio level.

Using rules of thumb estimates for future bond returns

A simple rule of thumb for bonds is that government bond yields tend to be about 0.5% to 0.75% below nominal GDP. We can extrapolate from this that real yields should be around the same level below real GDP growth.  Developed economies are expected to grow between 2% to 3% in real terms over the longer-term - so a 2% real yield assumption is not unreasonable over the longer term.

Common sense and a word of caution

It is important to remember that no-one has a crystal ball and expected returns come with a high degree of uncertainty in the short-term and maybe even the longer term.  Astute investors should run a number of returns scenarios to establish what this uncertainty would mean to them.  Halving expected portfolio returns is not a bad starting point for a basic stress test.

Sadly, it is not unusual to hear stories of less scrupulous advisers and product providers tempting investors with promises of spectacular returns on their portfolio.  A useful rule in investing is that if it sounds too good to be true, it probably is.  By and large, a return of 1% to 2% percent above inflation for bonds and 5% to 6% above inflation for equities is a sensible litmus test.  Returns much higher than these levels imply a material increase in the risks being taken on, which need to be fully understood.

Finally, remember not to beat up on your adviser because your portfolio has not delivered its expected return since you last met up – it is not expected to!

For more information on expected returns, see our latest Acuity newsletter.