Forecasting the investment weather

 

Forecasting ‘expected’ returns on portfolios is a little like forecasting the ‘expected’ weather in the UK.  Yet despite sensible generalisations – such as its usually sunny and warm in the summer and cold and frosty in the winter – we all know that the day-to-day, month-to-month and even year-to-year variation is high.

Given that it is holiday season, let’s start by taking a look at the weather in Aberdeen for August each year.  We know that it is likely that August will be warmer than January, and if we had to describe an ‘average’ day it would probably be mainly sunny, warm, with a gentle breeze and no rain.  In reality, a wide variation from our ‘average’ sunny day exists.

According to data, the average day is more likely to be cool, cloudy and windy, with a one-in-four chance of rain but with a lot of variation around this average outcome.  In fact, long-runs of unpredictable summer weather are the norm, not the exception.  The last few months have seen wonderful weather, but to make the point we still hark back to the fact that the last time this happened was in the summer of 1976, 42 years ago!

When it comes to making estimates of future investment returns, it is evident that there is no absolute certainty, only reasonable, informed choices.  Expected returns are not single point estimates of guaranteed returns – absolutely not – more of a reasonable assumption that will sit within a distribution of other possible returns.

You can perhaps see the challenge that your financial planner faces; having established what your money means to you and your family, and how hard these assets will need to work to meet your financial goals, he or she needs to estimate the future returns for each asset class and, in turn, for your portfolio, in order to build your financial plan.  This ‘expected’ return should be used as a starting point to see how well your financial plan works out; but to think that the expected return is some sort of accurate point estimate of how your portfolio will consistently grow, is to entirely miss the point.

It might be tempting to wonder why one bothers, but like knowing that summers are generally hotter than winters, we know that equities should return higher returns than bonds because they are riskier.  This risk-return relationship and the balance between the two is the important factor.

It is essential not to get fixated on the spurious precision of ‘expected’ returns, as none exists.  As with any average, you have a 50% chance of getting higher than the average and 50% chance of getting lower.  Knowing and planning for ‘what happens if…’ is a really important part of the planning process and ongoing discussions with your adviser.

For more information please contact Ian Campbell (ian.campbell@aabwealth.uk) or your usual AAB wealth contact.

To find out more about Ian and the AAB Wealth team, click here.