Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 228

Building better portfolios by forecasting markets

In the age of the 24-hour news cycle, many are devoting considerable effort into predicting the next market move. However, history has shown that trying to ‘time the market’ is extremely challenging even for the most astute of investors. Given this, how should we think about investing and constructing portfolios?

A report by Research Affiliates titled 'Pricing Stocks and Bonds' introduces a simple framework which sheds light on how we can forecast expected returns and construct an optimal portfolio. Instead of focussing on the short term, Research Affiliates argues there is greater value in forecasting long-run returns which can be predicted with greater reliability. Admittedly, even forecasts of long-term returns are unlikely to turn out accurately. But precision in forecasting is not necessary for constructing optimal portfolios.

They illustrate this via a simple framework which has outperformed a standard 60/40 portfolio (60% equity, 40% bonds).

Simplest return expectations

In our quest to estimate future returns, a crystal ball is not needed to foretell the future. Instead, they attempt to quantify the returns if everything unfolds as they expect (which admittedly rarely happens). Hence, they account for returns from unexpected events through the idea of an ‘unexpected shock’. In short:

Future Return = Expected Return + Unexpected Shock

To establish the framework, they examine a scenario where everything plays out as they expect. Imagine investing in a security with zero chance of default, does not pay dividends and is held until maturity. An example of this is a three-month certificate of deposit. In this case, the future return of the investment and the expected return today is known with certainty as the purchase yield of the investment. They look up its yield and know exactly what the future return will be. They can consider the same problem in a different way by asking the four questions below:

If the answer to all of the questions above is ‘yes’, then they know with absolute certainty that the future return of the investment is equal to its yield today. Of course, most of the time, there is no certainty about future cash flows, either due to default (fixed income) or due to cash flows that are not contractual (e.g. equity dividends). As they attempt to price a wider variety of investments, they begin to answer more negatives to these four questions. Consequently, the expected return moves away from the purchase yield and returns becomes more difficult to estimate. To overcome this, they adopt a framework based on long-term expectations.

Begin with a focus on the long term

To minimise the impact of idiosyncratic shocks in asset returns, they focus on long-term returns as they tend to be more predictable. One study found the volatility of 1-year returns to be 19.2%, while the volatility of 10-year returns was only 4.7%. However, unless the historical average of returns is accepted as the future expected returns, a tighter distribution of returns is of no great use. Instead, Research Affiliates documents below how to forecast expected returns.

1. Forecasting bond returns

Calculating an asset’s expected return is dependent on assumptions of certainty, size of cash flows, reinvestment rate, and holding horizon. Relaxing the hold-to-maturity and constant reinvestment rate assumption, they find that a strong relationship exists between the yield of a bond today and the yield of a similar bond issued a year ago. As a result, they use knowledge of bond yields today to predict future bond returns even if they do not hold the bond until maturity.

2. Forecasting stock returns

Forecasting stock returns is similar to forecasting bond returns, but they need to relax all four initial assumptions. This is because dividend payments are not fixed, equity holders can be wiped out by default, reinvestment rates change, and stocks do not have a maturity date. By relaxing these assumptions, dividend yield alone does not do a good job of predicting future returns. Instead, returns can be explained by three additional factors: inflation, growth in dividends and changes in valuation levels. The impact of these factors on returns can be seen below:

Research Affiliates finds the model does a fairly good job of predicting stock returns, however they concede they have often missed the mark. Forecasting returns is not an exact science.

Building a portfolio using expected returns

Using the expected returns generated, they proceed to construct a portfolio.

They allocate between stocks and bonds by comparing current expected return for each asset against its historical expectations. By doing this, they can form a ‘confidence score’ for stocks and bonds and allocate across these assets accordingly. For instance, if stocks have a high expected return versus its historical expected return, the model shows more confidence in the ‘cheapness’ of stocks and assigns a greater weight to stocks.

Using the strategy proposed, they find that it consistently outperforms a 60/40 portfolio across different rebalancing intervals, delivering superior returns with less volatility.

 

What this means

First, the framework does not imply they can predict short-term market moves. Instead, it focusses on long-term relationships that are more reliable.

Second, the proposed multi-question framework provides a useful approach for forecasting the future returns of any asset class. It is not limited to just stocks and bonds.

Finally, even if the long-term return expectations are not accurate, Research Affiliates argues they can construct portfolios which add value over a ‘set and forget’ portfolio.

 

Wilbur Li recently completed his Bachelor of Commerce (Honours in Finance) at the University of Melbourne and he will soon commence at a Melbourne-based fund manager. He has worked at Unisuper (global equities) and PwC (debt and fixed income). This article is general information and does not consider the circumstances of any investor.

RELATED ARTICLES

Investment performance and start date randomness

Understanding the benefits of rebalancing

Is your portfolio playing 20/20 or test cricket?

banner

Most viewed in recent weeks

Lessons when a fund manager of the year is down 25%

Every successful fund manager suffers periods of underperformance, and investors who jump from fund to fund chasing results are likely to do badly. Selecting a manager is a long-term decision but what else?

2022 election survey results: disillusion and disappointment

In almost 1,000 responses, our readers differ in voting intentions versus polling of the general population, but they have little doubt who will win and there is widespread disappointment with our politics.

Now you can earn 5% on bonds but stay with quality

Conservative investors who want the greater capital security of bonds can now lock in 5% but they should stay at the higher end of credit quality. Rises in rates and defaults mean it's not as easy as it looks.

30 ETFs in one ecosystem but is there a favourite?

In the last decade, ETFs have become a mainstay of many portfolios, with broad market access to most asset types, as well as a wide array of sectors and themes. Is there a favourite of a CEO who oversees 30 funds?

Betting markets as election predictors

Believe it or not, betting agencies are in the business of making money, not predicting outcomes. Is there anything we can learn from the current odds on the election results?

Meg on SMSFs – More on future-proofing your fund

Single-member SMSFs face challenges where the eventual beneficiaries (or support team in the event of incapacity) will be the member’s adult children. Even worse, what happens if one or more of the children live overseas?

Latest Updates

Superannuation

'It’s your money' schemes transfer super from young to old

With the Coalition losing the 2022 election, its policy to allow young people to access super goes back on the shelf. But lowering the downsizer age to 55 was supported by Labor. Check the merits of both policies.

Investment strategies

Rising recession risk and what it means for your portfolio

In this environment, safe-haven assets like Government bonds act as a diversifier given the uncorrelated nature to equities during periods of risk-off, while offering a yield above term deposit rates.

Investment strategies

‘Multidiscipline’: the secret of Bezos' and Buffett’s wild success

A key attribute of great investors is the ability to abstract away the specifics of a particular domain, leaving only the important underlying principles upon which great investments can be made.

Superannuation

Keep mandatory super pension drawdowns halved

The Transfer Balance Cap limits the tax concessions available in super pension funds, removing the need for large, compulsory drawdowns. Plus there are no requirements to draw money out of an accumulation fund.

Shares

Confession season is upon us: What’s next for equity markets

Companies tend to pre-position weak results ahead of 30 June, leading to earnings downgrades. The next two months will be critical for investors as a shift from ‘great expectations’ to ‘clear explanations’ gets underway.

Economy

Australia, the Lucky Country again?

We may have been extremely unlucky with the unforgiving weather plaguing the East Coast of Australia this year. However, on the economic front we are by many measures in a strong position relative to the rest of the world.

Exchange traded products

LIC discounts widening with the market sell-off

Discounts on LICs and LITs vary with market conditions, and many prominent managers have seen the value of their assets fall as well as discount widen. There may be opportunities for gains if discounts narrow.

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.