It’s not often you get to read such a sensible analysis of statistics as this! The implications for people trying to manage their pensions on the basis that on average they’ll get a 7.5% return on their pot are frightening, as good an argument for collective pensions as I’ve read this year!
Ask a random stock market ‘guru’ at the beginning of the year what he or she expects what equities will do that year and you will probably get an answer like this: ‘Well,… somewhere between the 5 and 10%.’ And this year is no exception. The average Wall Street forecast for the return on US equities is +7.5%. More importantly, this average includes very little outliers (see for example here and here). Plus or minus 20%, or even more extreme, is (almost) never the answer. And while that may sound logical, it is, in fact, not!
Sticking with the average
Please take a look at the graph below. It shows the calendar year returns on the Dow Jones Industrial Average Index since 1900, ranked from lowest (left) to highest (right). During this period, the return on the Dow Jones has averaged 7.4%. From this perspective, a return forecast of…
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If you ask the wrong question, you can expect to get an unhelpful answer.
Why not ask investment managers to explain the components of expected returns?
I don’t mean “attribution”, the unhelpful mathematical decomposition of an investment portfolio’s return compared to its tyrannical benchmark(s).
I do mean the total investment return, for example from equities which can be decomposed into four components: dividends, if any; expected inflation; expected real growth in the average business value of all listed businesses; and finally the volatile changes in Graham’s manic depressive, Mr. Market’s “perception” of the values of those individual businesses.
Or with bonds, the redemption yield.
Or with rental property, the initial yield, the expected growth in yield (if any) and the expected re-rating of capital values which can be realised either for reinvestment in other property with better prospects or taken back as net cash.
The answers won’t be as easy to assimilate as somewhere between 5 and 10, or better still perhaps somewhere between minus 30 and plus 35, but I think it’s a better question to keep asking, year after year.
What do others think?
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I think you are right to look at the fundamentals George. Decomposing the return as you do is instructive, it reminds me that all that really counts is the capacity of an investment to distribute a profits, the capital value is secondary – especially for pensioners , where inflation linked income streams are most important. That said, the capital value of these investments is all that most funds are measured by and to your point – it’s a poor proxy for the investment’s utility, thanks for reminding me of that
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