The best way to forecast investment performance is to examine the returns implied in asset current prices, writes DANIEL GRIOLI, investment analyst at FuturePlus. 

My last article challenged the notions that asset allocation is a new idea and that risk equals the volatility of investment returns.

It also highlighted the risk of anchoring, which is inherent in “dynamic” asset allocation. For each asset class in the portfolio, asset allocation requires an investor to determine the expected return, risk and correlation with every other asset class.

This is often referred to as setting capital market expectations. This article will focus on three approaches to estimating expected returns: forecasting future returns, historical returns and implied returns.

Accurately and consistently forecasting future returns is extremely difficult, while using historical returns as a guide to expected returns is fraught with risk. Instead, investors are better served by looking at the return that’s implied by the current price.

 

Forecasting doesn’t work

 

A common approach to estimating expected returns is to forecast a series of key economic variables and then use these forecasts to develop an expected return for each asset class.

For example, to forecast the return for equities, an investor may forecast variables such as inflation, economic growth, interest rates, company earnings, dividends and price/ earnings ratios.

These forecast variables are then used to calculate the expected return for equities. There is ample evidence to suggest that economists and analysts have great difficulty forecasting even a single variable, such as company earnings.

For example, a study by James Montier and Rui Antunes, of Dresdner Kleinwort, found that the average forecasting error on analysts’ predictions of future company earnings in the US and Europe was 43 per cent over 12 months and 95 per cent over two years.

Given how difficult it is to accurately forecast company earnings – a single variable – what is the probability of successfully combining several forecast variables into an accurate expected return for equities?

Let’s assume that it is possible to accurately forecast each variable 70 per cent of the time – a very high success rate as far as economic forecasts go.

If this were possible, the probability that the forecast return for equities will be correct is only 11.8 per cent (assuming that each forecast variable is independent).

Even when the success rate for each forecast is as high as 90 per cent, the probability of the forecast expected return for equities being correct is still not much better than for a coin toss.

Leaving probability aside, even if it is possible to correctly forecast asset class returns, this does not necessarily mean that forecasting is worthwhile.

Not only does the forecast need to be correct, in most cases it also needs to differ from the consensus – otherwise consensus expectations may already be reflected in the price and may consequently impact the expected return.

 

Does history repeat?

 

Using historical returns to forecast future returns assumes that history repeats. Unfortunately, when it comes to financial markets, this assumption is far from foolproof. As Warren Buffett once said: “If past history was all there was to the game, the richest people would be librarians.”

There is also the problem of what time period to use. Too short, and the data used may not include enough different market conditions and significant events to be a representative sample.

Too long, and the sample may include periods where financial markets and the economy were structurally different and may thereby include misleading information.

It is also important to note that historical returns – especially over the short term – are very sensitive to the choice of starting date.

While history may be of little help when it comes to forecasting future returns, knowledge of financial history can help investors to correctly identify periods of “irrational exuberance” or unwarranted pessimism.

These periods are particularly important as they represent both the greatest risks to and the greatest opportunities for investors.

 

Implied, not forecast

 

If forecasting future returns or using historical returns doesn’t work, how can investors assess the potential return of each asset class? One way is to work out the return implied by the current market price. There are several methods that can be used to do this. One method is to use a discounted cash flow (DCF) in reverse to calculate the implied return for an asset class.

A DCF model can be used to calculate the implied return for any asset that pays a cash flow. Let’s assume that we’ve reverseengineered a DCF model to calculate the current implied return for Australian equities, which is 10 per cent.

If the government bond yield is 5 per cent, then the equity risk premium (ERP) is 5 per cent. What does this tell us about the expected return for Australian equities? Finance theory assumes that investors will demand a return in exchange for risk. Investors must therefore answer the question: is an implied ERP of 5 per cent adequate compensation for the risk of investing in Australian equities?

Or to put it another way: are Australian equities cheap enough so as to provide a margin of safety? One way to answer these questions is to compare the current implied ERP with the historical ERP for Australian equities. According to the Credit Suisse Global Investment Return Yearbook 2011, the average ERP in Australia from 1961 to 2010 was 3.5 per cent.

An implied ERP of 5 per cent indicates that investors are currently demanding a higher return in exchange for the risk of investing in Australian equities.

One possible interpretation of this result is that Australian equities appear to be cheap as investors are currently offered a greater than average return in exchange for the risks of investing.

A second interpretation is that investors are currently more concerned about the risks of investing in Australian equities than they have been in the past. Of course the analysis above is only a simple example.

Ultimately investors will need to weigh the opportunities and risks to decide whether or not the implied return for Australian equities provides enough of a margin of safety, and consider questions such as:

• Does a high ERP suggest that Australian equities are cheap, that government bonds are expensive or a combination of both?

• Is the current implied ERP different for a structural reason – that is, a change in economic or fundamental conditions, which has led to a re-rating of equity risk? • Are current company earnings and dividends sustainable? If not, what are the risks?

One way that investors can explore these and other questions is by stress testing the implied ERP; that is, by varying inputs such as company earnings or dividend growth and seeing how these changes impact the current margin of safety.

While the analysis above is helpful, a prudent investor would never rely on a single measure when forming an opinion on the expected return of an asset class.

Such an investor would also consider market sentiment and other factors that are also important. As market conditions can change quickly, a prudent investor would frequently re-assess implied returns as part of their asset allocation strategy.

 

Knowing where we are now

 

Given the inherent uncertainty of financial markets, I would argue that investors are better served by working out what financial markets have currently priced in and positioning themselves appropriately, rather than speculatively trying to guess the future or looking to the past. As investors, we should concentrate on knowing where we are now.

Knowing where we are in the market cycle assists us in forming an opinion on the expected return and risk of each asset class. To do this, investors need to focus on what matters. This will be considered in my next article.

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