What return should I expect?on Monday, 18 February 2013. Posted in Financial Advice, Investments
Probably the most important theory in financial planning is Asset Allocation. Essentially the assumption that the returns you can expect over the medium to long term can be determined by what you buy. Bonds get lower returns, while equities get higher returns. For a long time the all academic research pointed in that direction, supported by industry research suggesting equity returns in 7-8% range. These numbers are quoted so often it isn’t considered cliché so much as a truism by the industry.
Recent, broader and deeper research however has thrown doubt on this suggesting a much lower rate of 3%. This is some well conducted research, so it bears some examination.
It also has profound implications for investors and financial planners. These are…
Asset Allocation IS the mainstream
It helps to understand why it matters so much. The key piece of research on returns is asset allocation indicating that selecting equities as an asset class represents 90% of performance is in a study by Brinson, Hood and Beebower. It isn’t just accepted; far more than that. This study and the others that followed are THE mainstream cornerstone of investment strategy. It is used by pension funds, taught by all major investment courses and is the foundation strategy of financial planners globally as taught by both CFP and CFA institutes. Everyone assumes that equities will return 7-8% and the equities are the highest performing asset class. The major choice is how much equities to buy to get you close to 7-8% long term.
America in the 60-70s isn’t a population survey.
The one problem was that research has been US focused since most researchers are themselves American. Don’t blame them, most researchers (and investors for that matter) have a home bias. As this Economist article mentions, America didn’t have a bad 20th century. When you go wider, much wider, to include all stock market history including all markets including Russia, China, and Austria and include their failures; things don’t look so pretty. In fact the research suggests that equities return 4% in the long term, not the 7-8% that is commonly accepted and expected. That’s not a small difference.
Small differences in cost matter.
If there is a chance that your stock market investment will only do 2-4%, then small changes in cost matter greatly. If your investment product has fees in the 4% range, then there is a good chance you will make nothing at all. Reducing it to 1% or less should be a high priority goal for any investor. We have spoken on this before (discount brokers, discount brokers), and will again soon. Funds that are exchange traded have recently become mainstream and are the best approach.
The past is no guide to the future
It may appear that we are doomed to low returns. We are not. It is worth pointing out that there is an awful lot of variance in the results. Some decades and long periods can be both wonderful and awful. The 1970s was dreadful with a 40% decline for the US market. The Japanese market is still around two-thirds below its 1990 peak more than two decades later. America had a great 1990’s as well as 1920’s, 1950’s and Australia had one of the best total returns out of any market (mostly due to dividends in the 3-6% range) during the 20th century. The record is mixed and points directly to two major learning points.
Exceptional results can happen, based on underlying economics
Argentina and Russia were, at one point, competitors to the US and failed in varying degrees. America succeeded and dragged its market with it. Where is the next America of the 21st century? China? Indonesia? Brazil? India? All could be mentioned as likely candidates. The record suggests that those investors who keep these markets as a small percentage of the “emerging market” bucket are potentially doing themselves a grave disservice. It also suggests that ignoring economic macro mismanagement is not a wise strategy. Russia in particular springs to mind here.
But what about the US going forward?
Another piece of research, again on the Economist website (have you got a subscription yet!) has looked at what might be expected over the next ten years. The methodology based on Shiller PE and market wide dividend yield. The results for the United States stock market are similarly sober, the one for government bonds horrific, but the outlook for property is considerably brighter. There are ways, besides buying a house yourself, and the associated management headache, to invest directly in property. To learn more email us on email@example.com.
So what do I take from this?
A few things:
- Look widely for opportunities since the past doesn’t guide the future.
- Economic growth matters in the medium to long term.
- Valuation and dividend yield always matter.
- Emerging markets may well represent the future, and we have discussed China recently.
- Property in developed economies could be interesting.
- Bonds have been great recently, but are due to underperform sometime soon.
Don’t go it alone
The final thing to remember is that investing shouldn’t be a solitary pursuit. There is so much to learn. We run open self-invest workshops regularly. The next event is March so join us.
We have also trained clients in managing their own money so email us here firstname.lastname@example.org or call (021) 3366 1337. We believe in clients and expatriates in general understanding investment options better. We run training programs, and lend investment books too. Does your financial adviser do that?
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