Rick Welch: Dollars and $ense

 Estimating Portfolio Returns

Would you build a house without blue prints? Of course not, because in attempting to do so you could waste lots of time and money and end up with a finished product that is well below expectations.  The same goes for investing. Without a solid plan or blue print, you may very well end up with a retirement that is well below what you expect or want.  The foundation for a solid investment plan is a strategic asset allocation which specifies the investment allocation for the three traditional asset classes; stocks, bonds and cash. In choosing the appropriate allocation (for example, 50% stocks, 40% bonds and 10% cash) you must balance risk and expected return in a manner that is appropriate for you and your circumstances.  History teaches us that choosing an appropriate long term strategic asset allocation is more important than the short term tactical asset allocation moves you may make along the way.

In order to estimate the expected return of your portfolio, you will first need to estimate what long term stock and bond market returns might be.  For 2014, Charles Schwab Investment Advisory reported the following long term expected returns for several different asset classes, including, US Large Cap (7.4%), US Mid/Small Cap (8.2%), International (7.2%) and Bonds/Barclays US Aggregate (4.8%).  In the case of stocks, reliable expected returns can be calculated using a historical long term approach or a valuation approach.  With the long term approach we consider the historical difference in returns between stocks and risk-free bonds (US Treasury bonds are the most common reference point) and make an assumption that the future will look like the past. The valuation approach suggests that the expected return of a stock is equal to the sum of its beginning dividend yield, plus long-term average real growth in earnings per share (EPS), plus implied inflation. The expected return of a bond is equal to the beginning bond yield at the time of purchase.  With bonds, we pay less attention to long term historical data and focus primarily on yield-to-maturity (YTM), which is flexible enough to capture the ups and downs of interest rate movements, while avoiding the shortcomings of assuming that trends suggested by historical data will repeat themselves in the future. There are several ways to approximate the expected return of cash, however, the one we favor is to use the estimated long-term inflation rate, which currently stands at 2.0%. 

To calculate the expected return of a portfolio, we must compute the weighted average of the expected returns on all of the assets in the portfolio, with each asset’s return weighted by the proportion of the total portfolio each asset represents.  So returning to our earlier example, lets calculate the expected return of a portfolio allocated 50% for stocks (30% to US Large Cap, 10% to US Mid/Small and 10% to International), 40% to bonds and 10% to cash. The mathematical expression would look like this:

                              Expected Return = .30(7.4%) + .10(8.2%) + .10(7.2%) + .40(4.8%) + .10(2.0%) = 5.88%

Investors should view expected return as one of the primary components of building an investment portfolio that will allow them to retire comfortably without needlessly sacrificing their lifestyle along the way.  It is important to remember that some tactical asset allocation adjustments may be necessary in times when short-term estimates deviate from long-term estimates.  In addition to prudent tactical asset allocation moves, investors will achieve higher returns through broader diversification, systematic rebalancing and the use of alternative investments, like REITs, MLPs, commodities and managed futures.

 

                                                                                                              

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