Forecasting the investment weather

Forecasting ‘expected’ returns on portfolios is a little like forecasting the ‘expected’ weather in the UK.  

Yet despite sensible generalisations - such as it's usually sunny and warm in the summer and cold and frosty in the winter - we all know that the day-to-day, month-to-month and even year-to-year variation is high. 

Let’s start by taking a look at the weather in Newquay, Cornwall for 1st August each year, to illustrate the point. 

We know that it is likely that August will be warmer than January, and if we had to describe an ‘average’ day it would probably be mainly sunny, warm, with a gentle breeze and no rain.  In reality, a wide variation from our ‘average’ sunny day exists.

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The weather in Newquay, Cornwall on 1st August, on average each year at 3pm  Data source: www.weatherspark.com

Forecasting the investment weather

When it comes to making estimates of future asset class returns, it is evident that there is no absolute certainty, only reasonable, informed guesses.  Expected returns are not single point estimates of guaranteed returns – absolutely not - as the chart below demonstrates.

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Expected after-inflation return distributions of short-dated bonds and global equities. Source: Albion Strategic Consulting.

You can see that the ‘expected’ return* sits within a distribution of other possible returns and the range of these potential outcomes is wider for equities than bonds. Summers are hotter than winters.  Planning alternative returns scenarios is, therefore, a critical part of building a robust financial plan.

To explore this subject in more depth, take a look at Volume 45 of Acuity.

* To be precise, the arithmetic return – not the compound or geometric return - sits in the middle of the distribution.

How good are we at predicting #investment returns? Better than we are at predicting the #weather?… https://t.co/As3nef5cFV