Real Returns by Dan Mikulskis

We’ve been through an amazingly benign and profitable time for investors in many financial markets, something I discussed further here.

That’s great to know, especially for those that participated. Not so  helpful going forward.

A better question is-

What’s your expected future return from equities (and other assets)?

Simple question, tricky answer. And one we hear a lot.

There’s plenty of long term evidence that investing in equities is likely to deliver an investor returns above the risk-free rate (for example Shiller, Barclays and Credit Suisse), however there’s also evidence that starting and end points can matter a lot, even over long time periods (check out this brilliant graphic from NY Times).

Despite the uncertainty on the future returns from equities, having an expected return figure is helpful for asset allocation planning and building portfolios. For investment consultants, its essential to have assumptions for this and other asset classes their clients might invest in.

At Redington we believe in building a margin of safety into our assumptions, as this leads to better outcomes for our clients (it’s one of our core investment principles). However we’re often told that our assumptions look too low when compared with our competitors, we’ve even lost out on business because of it.

What I’ve seen recently is more and more large asset management firms putting out long-term asset return expectations, including for equities. These firms are actually putting these out into the public domain for the first time. Of course, they aren’t saying how (or indeed if) they are using these returns for their own asset allocation, but surely the fact that they are prepared to put their name to it in the public domain means something. Check out the forecasts in the table below (note I appreciate there are some inconsistencies between them with regard to currencies and timeframes, but in the absence of a fully consistent dataset I think the overall message still holds).

What probably stands out to a lot of people from these expectations is just how miserly they appear, especially when considered relative to inflation or government bond yields. Most of the forecasts below fall around the 4% mark in absolute terms over 10 years, when taken relative to expected inflation of (say) 2% per year this implies real returns of just 2% per year.

Combining equities into portfolios with other assets (that generally have lower expected levels of risk and return than equities) it should become pretty clear to see it’s tough to put together portfolios that can deliver excess returns of 3% or more (above either gilts or inflation) without adopting some pretty outlandish assumptions. A point we’ve been trying to make for a while.

One thing we know pretty much for sure is that we’ll all be wrong – but of course the expected returns we use don’t influence the actual return we’ll get from equities (that’s the same, regardless of your view on returns now). What these assumptions will influence is asset allocation – and we firmly believe the best results come from incorporating a margin of safety.

If you use an investment consultant, actuary or other advisor with an equity expected return significantly above those below, you should probably ask them why.