Expected Returns and Asset Allocation

The greatest unknown for any investor if what return they can reasonably expect to receive on their investments into the future.  There are an infinite number of variables that can impact investment returns.

For example, the graphic below shows the range of returns over different time periods for a portfolio adopted by many Australian investors with a diversified holding of global equities since 1 January 1990:

Based on these results, if an investor asked what return they should expect from their share portfolio over the next year, a reasonable response would be somewhere between +40% and -30%.  That is a range of 70%!  But if their time horizon was 20 years, then the range certainly narrows – over the past 30 years, the range was +9.3% to +5.7% per annum – an average annual range of 3.6%.  Still, the compounding effect of an additional 3.6% per annum is material.

When helping clients create investment strategies best aligned with their goals, objectives and need and tolerance for risk, advisers need to assess the expected return for different mixes of assets.  In performing this analysis, advisers inevitably reflect on historical outcomes – like the graphic above – to help inform our decisions about the future.

If an adviser is too pessimistic about future expected returns, they may put a client into a portfolio with too much exposure to high-growth, high-risk assets, to try and produce the investment returns required to meet their objectives.  On the flipside, if an adviser is too optimistic, they may recommend a client holds too few growth assets, which over time may provide a return lower than expected or required.  

Short-term returns, as shown in the graphic above, are inherently volatile.  Whilst the US stockmarket has returned an average of around 10% per annum over the past century, only on six occasions has the calendar year return been between 8% and 12%. Assuming an investor receives the average return each and every year is a fallacy.

The challenge for advisers is to adopt assumptions around expected returns that enables their client to build a portfolio likely to deliver the returns they need to afford their desired lifestyle.

To help inform our members on how to approach the expected return and asset allocation decision, recently GAIA invited Philipp Meyer-Brauns, Head of Investment Solutions at Dimensional Funds Advisors, to present to our members.  The key matters we discussed with Philipp are detailed below:

  • Historical equity returns are noisy, and because of this, expected return estimates from historical data come with a lot of estimation error.
  • Many expected return models exist, like the Dividend Discount Model (DDM).  However, these models probably give a downward-biased estimate as there are alternative means to get cash to shareholders, and not all firms pay dividends.
  • For example, historical real equity returns for developed markets are in the range of 6% to 9% (with large standard errors).  Expected returns derived from the DDM range from 4% to 7% (with large standard errors).
  • For fixed interest returns, there are three inputs to the expected return, as shown in the graphic below:
  • The current yield curve provides information about two of the components of expected return, being Yield and Term.   As we have experienced in 2022, future changes in the yield curve are not always known and can occur quickly.  The recent increases in global inflationary expectations have had a historic impact on bond prices.
  • Looking at the expected returns GAIA firms apply to their asset allocation decisions, it is clear we collectively assume a lower expected return compared to historic returns.  On balance, it is prudent to be more conservative rather than optimistic.
  • Philipp still questioned whether being too conservative is reasonable.  After all, the past has had frequent and significant periods of market volatility.  Even in the past 30 years we have had the October 1987 stockmarket crash, high interest rates in the lates 1980s, the Tech crash of 1999/2000, the 9/11 terrorist attacks, the Great Depression of 2008-09, a global pandemic, and the current high inflationary environment. 
  • All GAIA firms regularly review and rebalance client portfolios to ensure the actual risk exposure does not stray too far from the target.  Many clients have their portfolio rebalanced every 6 or 12 months. 
  • Whilst rebalancing a portfolio is important to maintain an asset allocation aligned with an investor’s needs, goals and risk tolerance, any changes need to be weighed against the explicit costs (e.g. brokerage, custody fees, taxes) and implicit costs (e.g. bid-ask spreads).
  • Phillipp reviewed whether either of the following made a difference when rebalancing portfolios:
  • frequency
  • waiting for a portfolio to diverge a set percentage away from the target.

The graphic below looked at the monthly returns of portfolios rebalanced over a 40-year period, with the catalyst for rebalancing either being time (monthly, quarterly or annually) or divergence from the target (on a spectrum of 1% to 10%).

  • The conclusion was none of these factors made a material impact on portfolio returns, but if anything, you are better to rebalance the portfolio only when it is 5% or more away from the target.  So applying tolerance bands is more beneficial than strictly rebalancing a portfolio at set time periods.

Summary

The future is unknown, yet advisers need to establish and review assumptions around expected returns to help ensure our clients future cashflow needs can be met from their investment portfolio.  Philipp’s presentation assisted member firms to reflect on their current assumptions and benchmark them against the other GAIA firms, providing a plethora of information to take back to our Investment Committees for consideration.

Author: Rick Walker, Lorica Partners, Sydney

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