Return expectations: Fact vs. fiction
We hear guesses about what the market is going to do almost everywhere we turn. Finding useful insights amid the noise can be like finding a needle in a haystack. Unfortunately, exceptionally few of the estimates that are broadcast demonstrate any utility for investment decision making. The items below, however, highlight some of the most important insights about return expectations so that you can focus on the things most likely to help and avoid those that don't.
Short term vs. long term
The vast majority of return estimates proffered relate to the current year. As such, they suffer from the inherent deficiency that returns for any relatively short period such as a year are mostly unpredictable. While such estimates may be entertaining, they reveal much more about chance than they do about any information content that can be useful for long term decision making.
Past performance is not a guarantee of future results
Nonetheless, many industry participants disregard this warning by producing return expectations based on a statistical analysis of past results. Returns estimates based on history can provide a starting point for analysis, but taken alone can also lead to conclusions that can range from misleading to downright deceptive. Some common mistakes with historical analysis include overstating the returns investors are likely to actually achieve and failing to identify and incorporate important differences between past environments and likely future ones. Without such rigor, conclusions from these analyses tend to anchor on the past rather than to provide useful insight about the future.
Changing landscape
Some of the most difficult changes to see in the investment landscape are the ones that occur in long cycles, and yet these are often the ones that can have the greatest impact on future results. One of these changes in the global landscape is demographics. Most of the developed world is getting older and many emerging countries are rapidly catching up. Demographics change slowly, but also fairly predictably. As a result, it is easy to anticipate pressures on future economic growth both in the form of lower productivity and higher entitlement costs.
Another change in the global landscape is the substantial burden of debt. While this is a problem in the U.S., the problem is also spread across the majority of developed economies which makes it a global problem. One of the important insights from the influential book, This Time is Different, is that countries with high debt loads tend to grow slower. Unfortunately, this depressive force is likely to be exacerbated by weakening demographics.
A laudable goal
Ostensibly the main purpose of analyzing return expectations for long term investors is to determine the attractiveness of various asset classes. Certainly the exercise can facilitate tradeoffs, but it can also answer more fundamental questions. Do you get enough return to justify the risk of investing right now? There is no good reason to assume that all assets provide attractive returns all the time and history bears this out. As a result, a reasonable goal in establishing return expectations would be to adjust exposure to various asset classes so as to harvest the greatest opportunities from the market while mitigating its risks as fully as possible.
What methodology works?
One of the least asked questions in investing is, “What actually works?" The answer, fortunately, is that there are actually several methodologies for estimating future returns that work quite well for long term investors. One of the most popular metrics compares the cyclically-adjusted price-earnings ratio (CAPE) to average historical levels of CAPE. Estimates of subsequent returns from this methodology correlate extremely well with actual subsequent returns and therefore it provides a useful metric for evaluating the future potential of stocks.
Short term vs. long term
The vast majority of return estimates proffered relate to the current year. As such, they suffer from the inherent deficiency that returns for any relatively short period such as a year are mostly unpredictable. While such estimates may be entertaining, they reveal much more about chance than they do about any information content that can be useful for long term decision making.
Past performance is not a guarantee of future results
Nonetheless, many industry participants disregard this warning by producing return expectations based on a statistical analysis of past results. Returns estimates based on history can provide a starting point for analysis, but taken alone can also lead to conclusions that can range from misleading to downright deceptive. Some common mistakes with historical analysis include overstating the returns investors are likely to actually achieve and failing to identify and incorporate important differences between past environments and likely future ones. Without such rigor, conclusions from these analyses tend to anchor on the past rather than to provide useful insight about the future.
Changing landscape
Some of the most difficult changes to see in the investment landscape are the ones that occur in long cycles, and yet these are often the ones that can have the greatest impact on future results. One of these changes in the global landscape is demographics. Most of the developed world is getting older and many emerging countries are rapidly catching up. Demographics change slowly, but also fairly predictably. As a result, it is easy to anticipate pressures on future economic growth both in the form of lower productivity and higher entitlement costs.
Another change in the global landscape is the substantial burden of debt. While this is a problem in the U.S., the problem is also spread across the majority of developed economies which makes it a global problem. One of the important insights from the influential book, This Time is Different, is that countries with high debt loads tend to grow slower. Unfortunately, this depressive force is likely to be exacerbated by weakening demographics.
A laudable goal
Ostensibly the main purpose of analyzing return expectations for long term investors is to determine the attractiveness of various asset classes. Certainly the exercise can facilitate tradeoffs, but it can also answer more fundamental questions. Do you get enough return to justify the risk of investing right now? There is no good reason to assume that all assets provide attractive returns all the time and history bears this out. As a result, a reasonable goal in establishing return expectations would be to adjust exposure to various asset classes so as to harvest the greatest opportunities from the market while mitigating its risks as fully as possible.
What methodology works?
One of the least asked questions in investing is, “What actually works?" The answer, fortunately, is that there are actually several methodologies for estimating future returns that work quite well for long term investors. One of the most popular metrics compares the cyclically-adjusted price-earnings ratio (CAPE) to average historical levels of CAPE. Estimates of subsequent returns from this methodology correlate extremely well with actual subsequent returns and therefore it provides a useful metric for evaluating the future potential of stocks.
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