Great Expectations
Sadly, investors lost one of their greatest advocates last week, Jack Bogle, the founder of Vanguard and a pioneer of the index investing movement passed way. Jack’s legacy will be that he created a practical real-world application for a well-established academic idea. The efficient market hypothesis holds that the current price of an asset should already fully reflect all available information. Given this, it should be impossible to outperform the market by actively picking stocks or bonds.
While in the real world the idea of efficient markets is more a useful framework than an established investing law, it is true to say that over the long-run, market returns dominate the outcomes of most traditional buy and hold investment strategies. For a typical long-only stock portfolio, it would be normal to expect that what the market returns will explain at least 80% of your total portfolio return over time, if not more. Mr Bogle’s great achievement was to identify that most of the investment returns being delivered to investors in the traditional mutual funds of his day could be replicated for a fraction of the cost that was being charged.
To the great benefit of investors, the ‘Vanguard effect’ forced a dramatic re-pricing of fees across the investment management industry. It also established a fair hurdle that all active managers must now beat to justify their existence. Perhaps more important than this, Mr Bogle’s crusade also brought home to ordinary investors one of the most important underpinnings of investing, the fallacy that it is easy to consistently and predictably outperform the market.
That idea, that beating the market should be thought of as hard and unpredictable, is a vitally important concept with a number of significant implications. One area that many investors could benefit from extending their understanding of this to, is in setting their own investment expectations. Surveys typically show that investors are wildly optimistic when it comes to their own investment goals. For example, a 2017 global investor survey by Schroders1 found that 41% of Australian investors expected annualised returns of >10% from their whole portfolio over the next five years. Similarly, the most recent ASX Australian Investor Survey2 showed that the average return expectation for an Australian investor was 9%. What is more revealing than just these return numbers is what investors categorised as their acceptable risk tolerance. Fully 67% of the Australian investors surveyed by the ASX expected to generate their return target with a risk appetite that accepted only ‘guaranteed’ or ‘stable’ returns. Indeed, when asked about their current investment mix, the most prevalent investment held was cash, with 56% of those surveyed putting their savings in the bank, compared to only 51% who owned some shares.
An inconvenient truth
Whether we like to admit it or not humans are emotional actors. When it comes to investing, it is well established that we are prone to behavioural biases such as over-confidence and trend-chasing. After the longest equity bull market on record, it is perhaps understandable that some investors now have double digit return expectations in mind when constructing their portfolios. While highly ambitious, even at best this could only ever apply to those investors willing to bear the risks that come from a portfolio solely invested in higher-risk assets, like shares or private equity. There is of course nothing guaranteed, and very little that is stable, about investment into these sorts of asset classes – even if recent history paints a picture that might suggest it so.
Determining reasonable ‘long-run’ return assumptions for an asset class is an inherently problematic exercise. But as a starting point, most academics and industry experts would hold that long-run share market return expectations should be somewhere between 5% to 8% a year. While global share market returns have annualised at 9.7% in A$ terms over the last 10 years, over the last 20 and 30 years (horizons picking up both bear and bull markets) these returns have been 3.7% and 7.1% respectively. Given this, it is a particularly brave investor who uses a long-run return expectation of greater than 10% for a portfolio consisting only of shares. When we consider that cash interest rates in Australian today are only 2.1%, such return assumptions start to seem herculean for those investors with a low risk tolerance (guaranteed or stable returns). To meet such a risk profile, investors must hold significant weightings in cash and other low-risk/low-return asset classes.
For those that subscribe rigidly to the idea that markets are perfectly efficient, investors’ current expectations can never be fulfilled. Under the efficient market paradigm, it is impossible to outperform the ‘market’ while taking significantly less risk than the market.
Moreover, the same academic underpinnings that propelled Jack Bogle’s revolution on the investing world hold an even harder truth for investors today. We currently live in a world of low nominal growth and ultra-low interest rates that looks very different to the past. Over the 10 years leading up the global financial crisis, the average Australian cash deposit rate was 5.5% and real economic growth averaged 3.6%. Today growth is running at 2.8% and cash deposits return 2.1%. Economic theory tells us that, short of significant technological change (a possibility), future returns for investors should be a function of current interest rates and expected economic growth, both of which are much lower today than they have ever been in the past.
In the real-world markets are not efficient. There are managers and investment strategies that have shown that they can, to some degree, bend the risk versus return equation in favour of investors. Indeed, many of these strategies and managers can now be accessed by retail investors via the ever-expanding breed of new LIC’s arriving onto the ASX. There is a limit however, as to what investors should let themselves expect here. There is no magic formula for investing and no manager or strategy will perform as hoped all the time.
Hope is not a strategy
For the first time in years, many investors will have suffered losses over the calendar year of 2018, particularly over the final 6 months. While painful, times like this can serve as a great test to see if your risk profile matches your risk tolerance in both the good years and the bad. If your losses were greater than what you expect from time to time, it may be worth asking yourself some difficult questions about what you should realistically be expecting, and the risks you are willing to take to get there.
Judged by the survey findings, the average investor today expects high returns from a low growth, low interest rate world. More concerningly, these return expectations are being matched with an implausibly low risk profile. Over the long-run, those are not safe assumptions to make when planning for important savings goals like retirement. Happily, there is one sure-fire way to bridge the gap between unrealistic expectations and needing to provide for your retirement. It’s not very glamorous and we’ve all heard it before. Save more.
Miles Staude of Staude Capital Limited in London is the Portfolio Manager at the Global Value Fund (ASX:GVF). This article is the opinion of the writer and does not consider the circumstances of any individual. Mirabella Financial Services LLP is the investment manager of the Global Value Fund and has seconded the investment team at Staude Capital to manage the Global Value Fund.
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¹ Schroders Global Investor Study, 2017
² ASX Australian Investor Study, prepared by Deloitte Access Economics
