by James Parkyn
Anyone who is familiar with PWL Capital will know we don’t make predictions about the future direction of financial markets, the economy or anything else.
We accept the large volume of academic research confirming that no one can accurately forecast the future. Renowned economist John Kenneth Galbraith may have captured our attitude best when he said: “There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.”
Nevertheless, we still need estimates of future investment returns to use in financial planning models for our clients. For this purpose, we use future expected returns, and they are quite different from predictions made by analysts, pundits and gurus.
In estimating future returns our research team at PWL doesn’t pretend to know what will happen in the markets or the economy in advance. Instead, they take the average of all possible return scenarios for a broadly diversified portfolio of publicly traded investments over a 30-year time horizon.
They generate these scenarios by combining observations of current market conditions and more than 120 years of historical returns for various asset classes.
Of course, we don’t know which scenario will come to pass in the markets in any year, which explains why our research team also estimates standard deviation – the percentage that an actual return could fall above or below our estimate in a given year.
This last point is important. In the short-term, returns will likely be substantially different from the expected return. Over the long-term, however, the dependability of the expected return estimate increases (although there remains a substantial margin of error).
Last year was an example of short-term returns coming in far below long-term expectations for both the stock and bond markets. Both asset classes fell by double-digit percentages for one of the few times in history.
That was painful for investors, but the silver lining is that those market declines improved long-term expected returns, especially for bonds. We can see this in PWL’s recently published update of our Financial Planning Assumptions, authored by Ben Felix, Portfolio Manager and Head of Research, and Raymond Kerzérho, Senior Researcher and Head of Shared Services Research.
It shows that higher bond yields in 2022 produced a remarkable increase in our estimate for expected bond returns going forward. It climbed to 4.15% a year from 2.5% the previous year.
Gains in expected returns for stocks were less impressive because PWL’s equity estimates are based much more on historical returns than on current market conditions. Our estimated return for global stocks is 6.9% a year, compared to 6.6% a year earlier.
For a balanced portfolio composed of 60% stocks and 40% bonds, PWL estimates an expected return of 5.81% annually. Again, we can expect actual returns to deviate widely from this estimate in any given year.
Specifically, if we say the expected return is roughly 6% with a standard deviation of 9%, it means that two-thirds of the time, annual returns will be between -3% and +15%. The other third of the time the deviation will be even further from the mean. This is why investing often calls for patience and discipline.
PWL’s Financial Planning Assumptions makes a few other observations that may come as a surprise to you. Our research team estimates inflation at 2.4% annually over a 30-year-time horizon. That’s well below the current 5%+ inflation rate in the U.S. and Canada.
The report also estimates future returns for Canadian residential real estate market. Here, the recommended planning assumption is that an investment in a primary residence will return just 1% a year net of inflation, or 3.4% including inflation.
Return estimates are an important planning tool, but you should always keep in mind that we can’t know in advance what markets will return. Instead, you should seek to capture available returns as efficiently as possible while controlling risk through broad diversification and prudent asset allocation.
Then, it’s a matter of keeping the faith and patiently letting compounding do the work of building your wealth.
I encourage you to download a free copy of PWL’s Financial Planning Assumptions, and for more insights on investing and personal finance, listen to our Capital Topics podcast and subscribe to never miss an episode.