How can you know how much to invest without knowing what investment gains your portfolio may deliver in the future? Your portfolio’s expected return is the number you need.
Your expected return figure helps you plot a financial master plan that’s more robust than:
- Sticking your finger in the air.
- Consulting goat entrails.
- Getting your other half to pop on a veil on while staring maniacally at your palm and muttering “I see great fortune – but also much loss, my child,” in a cod Eastern European accent.
To calculate this critical number, you first need an idea of the expected returns of the asset classes you invest in. The numbers in our previous article on expected returns is a good starting point.
Especially useful are expected returns figures for individual asset classes as ventured by US passive investing champ Rick Ferri. Tim Hale has produced UK-centric figures in his superb book Smarter Investing
Choose whichever expert’s asset class return numbers seem most sensible to you, and then apply them to the asset allocation mix of your own portfolio:
Multiply each asset class’s expected return by its percentage allocation in your portfolio.
This gives you the weighted expected return of each asset class.
Add those numbers up to discover your portfolio’s expected return.
Here’s an example for a portfolio I’ve just made up:
| Asset class | Allocation (%) | Expected annual real return (%) | Weighted expected return (%) |
| UK equities | 15 | 5 | 0.15 x 5 = 0.75 |
| Developed world equities | 35 | 5 | 0.35 x 5 = 1.75 |
| Developed world small cap equities | 10 | 7 | 0.1 x 7 = 0.7 |
| Emerging market equities | 10 | 7 | 0.1 x 7 = 0.7 |
| Global property | 10 | 4 | 0.1 x 4 = 0.4 |
| UK government bonds | 20 | 0.5 | 0.2 x 0.5 = 0.1 |
| Portfolio expected real return | – | – | 4.4% |
Expected return source: Tim Hale’s Smarter Investing
Now do the same thing for your own portfolio. The figure you come up with is the real return you can expect your portfolio to deliver annually over the course of your investment time horizon.
See below for the caveats swirling like mosquitos around that breezy statement.
Using your portfolio’s expected return
Pop your portfolio’s expected return into an investment calculator along with your target income goal, time horizon and monthly saving dollop, and you’ve just thrown a rope around the task ahead.
Of course the one thing you can expect from any expected return number is that it will be wrong to some degree. But at least you’re no longer shooting in the dark, and you can correct your trajectory as you go.
Once you know how to estimate your portfolio’s expected returns, you can also start doing groovy things like customising your asset allocation to better fit your individual needs.
For example, if your portfolio’s equity allocation is higher than you’d like – because you’re nervous of volatility – then notch up the bond allocation in your calculations and see what difference it makes to your expected return.
Rerun the numbers and if you can still hit your financial goal within an acceptable time frame then you can afford to take less equity risk.
If you add riskier but higher expected return assets like emerging markets, small cap, and value equities then the expected return (and volatility) of your portfolio heads higher.
Again this may give you the headroom to increase the bond component of your portfolio and lower the equity allocation – potentially reducing risk without sacrificing the expected return you need.
Caveat city
No Monevator post would be complete without a sprinkling of snares, trip-mines, and general financial doo-doo for you to hopscotch over.
Here’s this episode’s selection.
Subtract your fund’s charges and platform’s fees from each line of your expected returns. Ditto for any investments exposed to tax. Nothing is more certain to dent your plans than the ongoing costs of investment.
Make sure you adjust your calculator, too, if it already assumes an allowance for these costs.
Remember to check if your expected returns are quoted as real returns or nominal returns.
Real returns are what you’re left with after inflation has taken its bite. If you’re using nominal returns then just subtract an estimate for inflation before you start: 2 – 3% is reasonable for UK investors.
The current UK government bond yield minus inflation is the best guide to the expected return of UK gilts. Choose the maturity that best represents the average maturity of your bond fund or ladder.
Expect (a bit of) the unexpected
They say always end on a song, but they probably don’t write personal finance articles for a laugh
So I’m going to end with a warning instead: Expected return numbers are expected because they take historical performance and recent valuations into account.
As such, expected returns are more credible than the prophecies of the Ancient Mayans, but they can still be wildly off-beam because the dispersion of investment returns resembles a shotgun blast.
Take it steady,
The Accumulator
Comments on this entry are closed.
The biggest risk seems to be that the countries you are invested in end up on the losing side of a big war. Over the last century Australia, South, Africa, Sweden, New Zealand and Canada have done quite well. The losers – Germany, France, Belgium, Italy, Russia, China and Austria have done much worse.
Unfortunately it seems completely impossible to predict wars(even with all the phone tapping we were unable to predict the Syria or Ukraine situation). I suppose this is probably another argument for geographic diversification.
If we’re all going to be allowed to do what we like with our own pension pots in future, then – except for those planning to blue the lot on a Lamborghini o.n.o. – the time-scale changes from “until I want to retire” to “until I (might) drop dead”.
Depending on whether one wants (or needs) to leave some capital to support any dependant(s), that might mean changing focus, surely? If I’m happy to use up my pension savings during my own lifetime, then there might be arguments for maximising income without preserving capital for any longer than necessary.
Actuaries may have a slightly different role to play in the post-Budget world, don’t you think?
Interesting stuff and useful to do however I am always very wary of predicting equity/bond returns in one shot.
The ‘beta’ (the diff between the market assumptions and your specific portfolio/holdings) nearly always makes these kinds of estimates worthless, unless of course you are really really well diversified.
Rather than using one sole ‘expectation’ for my portfolio, when doing my longer term planning I usually use number of scenarios e.g. +2%, +5%, +10% etc. This way I have a good/bad and ugly view of how my portfolio might treat me in the future.
Great post! Even if it’s just a method of determining an estimate, the end figure can help you to determine if your doing too little or maybe even too much. For someone who has just gotten the ball rolling, it’s invaluable advice.
Grand
@ Under The Money Tree – a very wise approach. I must admit +2% projections always have me crying into my spreadsheet while +10% has me singing songs from Fiddler On The Roof.
@ Diana – yes, the goal of anyone who has no need for legacy is to consume as much of their money as possible in their lifetime. The logical extension of this is that the ideal amount of money left in your pot when you shuffle off is £0. Many wealth managers and academics who specialise in pension planning would view that as the ultimate success of a withdrawal strategy. The trick is predicting your demise. Personally, I don’t mind leaving a bit for the cat’s home 😉
I take my asset class return estimates from here.
http://www.investmenteurope.net/digital_assets/6305/2013_yearbook_final_web.pdf
I have to say, I’m more interested in trying to work out my portfolio’s actual return than estimating what it might be. I find that surprisingly complicated to work out, trying to separate the new money from the growth. The IRR function isnt really what I’m after either, because I want to know the ACTUAL return rather than the notional annualised figure. I know it just boils down to a few sums, but it’s still harder work than I’d like!
One possibility the new ISA rule changes open up is for bond-o-phobes (those fearing a long bear market in bonds due to rising rates) to reduce equity risk by running a portfolio consisting of 50% Cash ISAs and 50% equity trackers in a SIPP. E.g. the SIPP itself could be 100% invested in equities, or at least a fairly aggressive 80:20 regardless of age.
While you could do this before with smaller amounts, the limits on Cash ISAs have nearly tripled so it opens up this approach to more people.
Not one I will personally consider though until Cash ISAs offer a real return over inflation.
Is Excel just the modern equivalent of examining goat entrails?
Apart from inflation linked bonds held to maturity there isn’t much that offers a guaranteed return
Anything else is just a what if scenario
Worth doing a couple of ways once a year – yes, for sure
Reliable guide to the future – er, no
@ The Accumulator – That was the underlying idea, yes: but I was interested in how investment planning should be adjusted to achieve it. (A residual legacy to the cats’ home, or equivalent, will always be needed to avoid the Treasury getting an undeserved windfall.)
For instance, rather than the traditional thinking that one should hold ever more bonds as one ages, this might justify keeping more equities.
Is 5% for UK equities not pretty low? The average total return for the FTSE 100 index in the last decade has 9.2%. Is this an index fund?
@john
i think the 5% is real return, ie not including inflation
@ Vanguardfan
I suffer from the same problem, also find it surprisingly hard to work out how well I’m tracking to the ‘grand plan’… Perhaps when you’re low on future ideas an article on tips on making the tracking part easier would be most welcome.
Keep up the good work, another useful article!
@ John – The real return on UK equities 1900 – 2013 is 5.3% 2000 – 2013 it’s 1.2%. Check out page 59: https://publications.credit-suisse.com/tasks/render/file/?fileID=0E0A3525-EA60-2750-71CE20B5D14A7818
@ Diana – There is a massive body of research into this area. Look up Wade Pfau and Michael Kitces who offer excellent entry points. Also William Bernstein’s short book: The Ages of the Investor.
Annuities are one way of ensuring you will have enough money until you die as are bond ladders that closely match your life expectancy (actuary tables can be used to estimate this) but my flippant cat’s home comment was really my way of saying you don’t want to cut it too fine.
Here’s a piece on the role of equities in retirement portfolios: http://monevator.com/buy-shares-in-retirement/
I believe the best way to properly track your returns is via your own spreadsheet and ‘unitization’, so new money brought into your portfolio buys more ‘units’ in your portfolio, and money that leaves is represented by selling units.
This is what I do and it works very well. (It’s especially great if you’re an active investor and thus prone to deluding yourself).
It also allows apples to apples comparisons with the returns from fund managers.
I have had a half finished post on this knocking about for around 3 years. I’ll try to finish it soon! 🙂
Thanks TI, I’m sure that will be useful to many. At the moment, my tracking system really is as basic as adding up all my accounts (including cash) every few months and then trying to separate new money from growth. Even this is surprisingly difficult to pin down, as the sands are constantly shifting and I try to exclude money earmarked for short term spending.
I guess I’m just not enough of a spreadsheet nerd to be motivated to track this level of detail. To put it in context, the next ‘tedious spreadsheet task’ on my to-do list is to document and examine current household expenses, which I haven’t done since we moved six months ago so I have little idea what impact the move has had on essential expenditure. And I know that is far more important for understanding whether my retirement plans are on track.
My current investment priorities are to simplify and automate, write down my asset allocation to stop me constantly re-deciding it, and minimise costs – ie try to minimise the behavioural biases I have identified in myself…(I am fully passively invested but even so find it far too easy to fiddle or be distracted by the next good idea/views about market valuation). I should probably give up reading financial blogs as well 😉
@The Accumulator – If you go to this link on the FTSE website and take the average for the FTSE 100 total return over the last 10 years, you will see the total return including dividends, averages out at 9.1%.
http://www.ftse.com/Analytics/FactSheets/Home/FactSheet/ProductRegions/ASX/1/EUR/1?fromftse=true
That is if you are buying an index fund or etf.
You could try tracking your portfolio using MorningStar’s Portfolio Manager. Trustnet have a version too. Both free.
@Diana – if you are looking to maximise your income while guaranteeing it won’t run out then isn’t that what an annuity does? I suspect we’ll still see a role for them for some older people as they start to wrestle with how they achieve this delicate landing of exhausting their pot at death.
I have been looking at sustainable withdrawal rates and the big problem otherwise is that you need to keep withdrawals low for the risk that things go well on lifespan, or really badly with investments. So it is hard to get the most out unless you’re either prescient or willing to run with a very high risk of running out.
There are some interesting pieces of research out there, but it then comes down to weighing up probabilities which is a very tricky question. Am I happy with 5%, 10% or 25% chance of ‘ruin’?
I use trustnet to track my portfolio, it’s really helpful. I am nearly at the point where my portfolio mirrors my asset allocation plan, which is not bad as I only started in June. Broadly speaking the portfolio tracks between 3 and 5% and is roughly 80/20 split, mind you I think I’ll be happier at 75/25 but that 5% tilt in fixed interest not based in the UK.
Grand