Be cautious about your return expectations

By Larissa Fernand |  21-10-21 | 
 
No Image
About the Author
Larissa Fernand is Senior Editor at Morningstar.in. Follow her on Twitter @larissafernand

Every time we purchase an asset, we express confidence in the future: that companies will grow their profits, borrowers will repay their debts and governments will allow capital to move freely around the world.

Investing is an exercise in optimism. Without optimism, there could be no capital markets, no entrepreneurship and ultimately no human development.

Nevertheless, Dan Kemp, Morningstar Investment Management’s Global CIO, made a case for realistic optimism.

Be cautious about your optimism.

Too much optimism can be dangerous for investors, as it can alter our behaviour leading us to take too much risk.

In a survey of 8,550 investors across 24 countries, asset manager Natixis recently found that, on average, investors expected an annualised long-term return from equities of 14.5% above inflation. If we assume long-term inflation is 2%, this equates to an annualised nominal return of 16.5% – or 360% over a 10-year period.

According to S&P 500 data from 1871 to today, a 10-year real return of this magnitude has only occurred 7.35% of the time. Even more strikingly, this probability falls to just 0.36% – that is, a 1 in 277 chance – when the starting point is at an all-time high. A reasonable base rate expectation for equity returns is around 7.5%, if the empirical evidence is our guide. This leaves an enormous gap of around 7% between current expectations and historical norms.

Returns are likely to revert to a long-term base rate. This will quell the optimism that emerges during periods of high returns and combat the pessimism that accompanies bear markets.

6 nuggets of wisdom for equity investors

Be cautious when thinking about expectations.

When thinking about returns, investors tend to suffer from ‘base rate neglect’. They ignore long-term data – the base rate – when making forecasts, in favour of a more recent experience or an appealing narrative.

One of the reasons expectations have strayed so far from a reasonable expectation is that investors tend to be conditioned by recent experience. The expectations stated by investors are similar to those received over the last three years – 15.2% real returns per year – despite the fact we are starting from a very different position.

While it may be reasonable to increase return expectations as the economic conditions become more supportive, it is essential to consider the expectations that are already discounted in the share price of companies as, if they are to be sustainable, all gains in the price of an asset must ultimately be reflected by the underlying earning power of that business. This is what Howards Marks eloquently describes as ‘second-level thinking’.

4 questions to ask before you sell equity

Be cautious in your focus.

We tend to channel our thoughts to what we perceive to be the most relevant information, often to our own detriment.

It is for this reason that a valuation anchor is so important. While it has become fashionable to dismiss traditional valuation metrics – and reasonable to debate the relevance of asset-based valuation models in an environment where asset-light businesses can generate both high growth and high returns with little capital – it is also worth remembering a reasonable valuation of an asset is the only defense we have against excess optimism (or pessimism).

In today’s context, the danger for investors is twofold.

First, they will save too little as they expect their invested capital to make an unrealistically large contribution to meeting their financial goals.

Second – and perhaps more dangerous to their long-term goals – is the failure to achieve the expected, but unrealistic, returns may discourage them from making additional investments or may even lead to them selling those they already have and, in doing so, destroy the benefit of long-term compound returns that lies at the heart of every successful investment strategy.

7 pointers when averaging up on a stock

Dan Kemp authored Always look on the bright side, from where the above excerpts have been taken.

Add a Comment
Please login or register to post a comment.
<>
Top
Mutual Fund Tools
Ask Morningstar
Feedback