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The tricky business of forecasting investment returns

03 June 2019

3 minute read

Forecasting investment returns is a tricky business: there’s always going to be an element of uncertainty, but how much? The bad news is that there’s no crystal ball. The good news is that long term investors might not need one.

Who's it for? Confident investors

What you’ll learn:

  • What returns should we expect from investments?
  • A few simple forecasting rules.
  • The benefits of diversification and investing with a long time horizon.

What returns should we expect from investments?

This is arguably one of the most crucial things to know before building a portfolio: after all, there’s no point investing in something with poor prospects. But of course we can’t see the future, and disclaimers frequently remind us that past performance is not to be relied upon either – so what to do?

It’s probably not worth even trying to forecast the fortunes of individual companies: it’s simply too unpredictable, like trying to guess how much you’ll spend at your next visit to the supermarket. Maybe you’ll be tempted by something on offer? Maybe you’ll try a cheaper brand to save money?

But the supermarket’s daily takings as a whole should be more stable: some customers’ frugality will be offset by others’ indulgence. This is one of the benefits of diversification1; as individual differences are smoothed out, we are left with the overall trend. In the world of investments, that means it’s best to stick to broad types of assets.

One way to go about it is to measure how “popular” each asset class is, according to how much is invested in them, and compare this with how risky they are. This idea is rooted in modern portfolio theory, and suggests there is a relationship between risk and return; namely that investors will probably only put their money into high risk investments if they expect to be compensated with a healthy return2.

On top of this, we can add our own personal estimates of the potential returns on offer. Naturally, there is lots of research on ways in which to gauge the likely performance of markets. Sadly though, there’s no crystal ball.

A few simple rules of thumb

Nonetheless, there are some simple rules of thumb that can be useful: for example, there’s evidence to show that changes in a stock’s value can have a large effect on its returns over the short term. However over the longer term, economic growth and other drivers of growth (for example at the company or sector level) often play a larger role3.

As such, this isn’t to say that it’s better to delay investment until forecast returns are stronger. In waiting for the perfect moment – which may never come – we may end up foregoing a handsome profit4. In short, we should remember that forecasts carry a large margin for error.

It’s therefore prudent not to lean too heavily on a single number for an expected return – it should come with a description of the uncertainty surrounding it. For example, an estimate of how long it will take to complete a journey by car might range from 40 minutes to an hour, depending on traffic conditions. The difference between the upper and lower ends of the estimate – 20 minutes in this case – is known as the confidence band/interval5.

It’s important to note that expected returns and confidence ranges vary with the time horizon over which they are made. Put simply, the longer the investment period, the wider the spread of potential returns.

The good news for long term investors is that, whilst confidence bands expand over time, they do so at an ever slower rate. This means that the range of annualised returns actually shrinks with a longer investment horizon.

Investor conclusion

Just as it’s easier to anticipate the path of a cloud than the individual droplets from which it’s formed, we can better predict the fate of broad asset classes than single companies. And the long term trajectory may be easier to trace than the erratic swings witnessed over a short time horizon.

But ultimately, we have to accept that we can’t foresee the return on our investments. Perhaps, though, we don’t need to. If you believe that owning shares in a company is likely to give you more upside than lending it money, and that the world isn’t imminently about to end, then it makes sense for your portfolio to be tilted towards equities – as you are willing and able to take the risk – whilst remaining prudently diversified. Then leave it to grow, however it may.

Where to invest?

The Barclays Ready-made Investments are just one example of a range of diversified funds which allow you to select the level of risk you are most comfortable with. These multi-asset funds invest across a range of asset classes and regions, offering a globally diversified one-stop solution for investors.

You should only be thinking about holding these investments for at least five years as they’re designed for the long term.

All of these investments can fall in value as well rise; you may get back less than you invest.

These are our current opinions but the future, as ever, is uncertain and outcomes may differ.

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The value of investments can fall as well as rise. You may get back less than you invest. Tax rules can change and their effects on you will depend on your individual circumstances. Smart Investor doesn’t offer personal financial advice. If you’re not sure about investing, seek independent advice.

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