What does the weather in Cornwall have to do with your investment portfolio? Richard Wood explains.
What’s the weather going to be like in 2021? We have a growing wealth of data, science, models and common sense on which to build forecasts. Yet despite generalisations – such as it’s usually sunny and warm in the summer and cold and frosty in the winter – all we know is that the day-to-day, month-to-month and even year-to-year variation is high.
‘Expected’ returns on portfolios are a little like the ‘expected’ weather in the UK. Investors should never believe that expected returns are accurate, single point, consistent outcomes. Generalisations, grounded in empirical data, sensible rules of thumb and common sense are immensely important starting points for useful, informed discussion and scenario modelling.
Despite our deeply embedded childhood memories of everlasting warm and sunny summers, nothing is certain. 2018, for example, was the second-sunniest summer on record, but long-runs of unpredictable summer weather are the norm, not the exception.
Parallels exist in investing when it comes to trying to forecast future market outcomes.
We can’t predict the future
Obviously, if we could completely trust forecasts of future returns on asset classes used in portfolios, we would simply invest in the highest returning asset class and ignore all the others.
Yet it is the very uncertainty of outcomes for which investors are compensated.
For example, holding a five-year index-linked gilt to maturity has a far more certain outcome than owning shares in a small unlisted biotech company, struggling with another funding round. In the former case, the UK government will pay you back at maturity and protect your income and capital from inflation.
In the same way that we broadly accept from the data, science and logic that summers are warmer than winters in Cornwall, we also know that more ‘risky’ investments with wider ranges of potential outcomes – such as the small unlisted biotech company – are likely to have higher returns than lower risk investments with narrower ranges of likely outcomes.
Most of the time this works out, but not always. As Nobel prize-winning physicist Niels Bohr pointed out, “Prediction is very difficult… especially if it is about the future.”
Great expectations
This is the challenge your financial planner faces. Having established what your money means to you and your family, and how hard these assets will need to work to meet your financial goals, they need to estimate the future returns for each asset class and, in turn, for your portfolio, in order to build your financial plan.
This ‘expected’ return should be used as a starting point to see how well your financial plan works out. But to think that it is some sort of accurate point estimate of how your portfolio will consistently grow, is to entirely miss the point.
Building asset class assumptions
When it comes to 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 horizons being modelled in clients’ financial plans.
Over these long time periods, current market valuation levels and initial yields are less influential than historical long-term data and economic logic.
A rigorous approach helps ground the central case for assumptions within sensible and defensible parameters. An expected asset class return is simply the most likely – i.e. probability adjusted – outcome from within a distribution of possible outcomes.
While long-term historical data is a useful starting point – even with data in the UK going back to 1900 – it’s not enough to confidently deliver a level of precision.
The annual average after-inflation (real) equity return in the UK has been around seven per cent, giving a compound after-inflation return of five per cent with a risk of 20 per cent. Statistically speaking, we can be 95 per cent confident that the true average annual equity return falls within the range of 3.3 per cent to 10.5 per cent, but no more precise than that!
To put it in weather terms, statistics going back to 1980 show that the average temperature in Newquay, Cornwall is 18.5° at 3pm on August 1, with a standard deviation of around 1.7°. Therefore, statistically, we can only be 95 per cent certain that the true average falls within a range of 17.9° to 19.1°.
Comparing the performance of short-dated high quality global bonds with global developed market equities shows that returns fall within an average range, +/- 20 per cent for equities and +/- 5 per cent for bonds.
These individual asset class assumptions can then be built into portfolio level expected returns. Like the weather in Cornwall, expected returns come with an average outcome that lacks certainty in its magnitude, and that around this average a wide range of alternative outcomes could occur.
It might be tempting to wonder why one bothers but, like knowing that summers are generally hotter than winters, we know that equities should bring higher returns than bonds because they are riskier. This risk-return relationship provides a useful framework for suitable portfolio construction made up of multiple asset classes.
Don’t get fixated on ‘expected’ returns
If there is any message worth taking away from this, it is not to get fixated on the spurious precision of ‘expected’ returns, as none exists. As with any average, you have a 50 per cent chance of getting higher than the average and 50 per cent chance of getting lower than the average.
Knowing and planning for “what happens if…” is a really important part of the planning process. To put it another way: it’s always a good idea to pack a weatherproof jacket when going on holiday, as the sun does not always shine. Although, on average, it might be expected to do so in Cornwall in August.