The expected return is the average annualised1 growth number that you can reasonably hope your portfolio will deliver over time.
With a credible expected return number you can work out whether you’re investing enough money to meet your goals before the clock ticks down.
But what on Earth does a credible expected return look like?
Great expected returns
We already know that a volatile asset like equities could fruitlessly gobble up most of our coins in the years ahead, or else deliver a three cherry win on the one-armed bandit of life.
Or most likely something in between. Nobody can say for sure.
But the wild variations in outcome tend to even out over time. So one reasonable method for estimating your expected return is to look back at what equities and bonds have produced since reliable records began – that’s around 1900 in the UK. You’ll see this figure in my table below.
However, many commentators believe that the last five years of historically low interest rates and Central Bank counter-measures have changed the game.
The consensus gel has hardened around the idea that equities’ historic verve is being sapped by near-zero interest rates. The theory goes that investors are only prepared to invest in risky equities (as opposed to stable cash and government bonds) because they earn a bonus for doing so.
This bonus is known as the equity risk premium.
Historically, equity investors in the UK have earned a risk premium of more than 4% over cash. As returns on cash and bonds are currently being suppressed by low interest rates, that implies that equities will be held back, too.
In other words, if cash historically returned about 1% a year, then an equity risk premium of +4% would imply an average return from equities of 5%.
But if cash is likely to return 0% in the years ahead, then equities can still only be expected to return +4% over that. Which sadly would mean equities only raking in 4% a year, on average – well below the historic norm.
Fat tails of the unexpected
Given the uncertainty ahead, I’ve gathered a selection of credible return estimates from a range of independent analysts and commentators from both sides of the Atlantic. (I think it’s useful for UK investors to be aware of the US perspective, because passive investors are likely to have as much as 50% of their equity portfolio invested in American companies.)
Remember, there’s nothing baked-in about any of these numbers. They are long-term ranging shots designed to give you a realistic prognosis for what lies ahead – but no guarantees!
Each and every one of these sources would be the first to say their number will be wrong. That’s why some sources offer a range of probabilities.
It’s also important to note that the numbers do not speak of the fevered gyrations that can grip the markets at any time. Your wealth won’t smoothly escalate by a pleasant 4% to 5% a year.
On any given day you have a 50-50 chance of tuning in to see a loss on the equity side of your portfolio. Every year, there’s on average a 30% chance of a loss.
This measure is known as standard deviation.
- If your expected return is 5% but the asset’s standard deviation is 20%, then two out of three annual returns can be expected to fall roughly within the range of -15% to +25%.
- Nineteen out of 20 returns would fall within two standard deviations: -35% to +45%.
In other words you can expect your actual returns to be about as smooth as sandpaper toilet roll.
- The UK’s biggest real-term loss for equities was -71% in 1973-74. It took ten years for investors to break even again.
- Meanwhile on the bond side, investors endured a -73% real-term loss between 1947 and 1974. They only fully recovered in 1993, 46 years after the slide began.
We can aim to avoid this kind of nightmare by diversifying globally.
Many happy expected returns?
You can use the range of expected return numbers below – high, low, and intermediate – to test the durability of your plan as you plot your own scenarios.
You may be shocked at the difference between the worst and best cases.
If your goal is mission critical then take action to ensure you smash through the tape, rather than hoping to scrape over the line.
Note: These annual return forecasts are in real (after inflation) terms.
|Forecaster||Equities (%)||Gov Bonds (%)||60:40 split (%)||Forecast
|Dimson, Marsh, Staunton||3-3.5||0.5||2.15||Feb 2013|
|UK historical||5.2||1.5||3.72||Feb 2013|
|World historical||5||1.8||3.72||Feb 2013|
Sources and notes:
Rick Ferri – US passive investing champion and wealth manager. 30-year forecast. Equities figure is for developed world stocks. Bonds figure is for 10-year US Treasury Notes. Click through for more asset classes.
Dimson, Staunton and Marsh – Professors at the London Business School. 20- to 30-year forecast. Equities figure is for developed world stocks. Bonds figure is for 20-year UK Government bonds.
Harold Evensky – US wealth manager. Figures for developed market and US Treasuries.
Tim Hale – UK passive investing champion and wealth manager. 20-year forecast. Equities figure represents a portfolio including emerging markets, small cap, value, and global property assets. Bonds figure refers to UK Gilts with 0-5 year maturities.
FCA – Report by PricewaterhouseCoopers. Used as basis for regulatory pension projections from 2014. A 10-15 year forecast. Equities figure is for UK stocks. Bonds figure is for 10 to 15 year UK Gilts.
UK and World historical – Dimson, Marsh, Staunton (again). Credit Suisse Global Investment Returns Yearbook 2013.
Take it steady,