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 [1] 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 [2] you invest in. The numbers in our previous article on expected returns [3] is a good starting point.
Especially useful are expected returns figures for individual asset classes [4] as ventured by US passive investing [5] champ Rick Ferri. Tim Hale has produced UK-centric figures in his superb book Smarter Investing [6]
[7]
Choose whichever expert’s asset class return numbers seem most sensible to you, and then apply them to the asset allocation [8] 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 [6]
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 [9] along with your target income [10] goal, time horizon and monthly saving dollop [11], 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 [12]– then notch up the bond allocation [13] 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 [14] 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 [15] 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 [16] and platform’s fees [17] 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 [18] 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 [19] 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 [20] of investment returns resembles a shotgun blast.
Take it steady,
The Accumulator