How to Predict the Future – Our Investment Director Answers Back
In recent blog articles we suggested that we could improve investor’s returns by changing the mix of assets in our portfolios to reflect changing conditions. But in Our Very Latest Opinion on Markets we said, "....accepting that you really don't know which will be the best performing area over the next 12 months is one of the most important steps to becoming a successful investor.” So is it possible to profitably predict the future, or not? Our Investment Director, Richard Urwin, provides the answer.
These two statements may seem at odds with one another but they can easily be explained. In the words of Derek Tharp PhD:
"a look at real-world data reveals that…market returns seem to exhibit at least two different trends. In the short-run, positive returns are more likely to be followed by positive returns, and vice-versa; and in the long-run…..periods of low performance are followed by periods of higher performance and vice-versa.”
Our belief is that we cannot predict with any accuracy the return of different asset classes over shorter time periods of 12 - 36 months. However we do believe that we can take a view on the valuation levels of different asset classes relative to one another and relative to their historical average to arrive at conclusions about how to invest profitably for the long term.
The way we run our clients’ portfolios is built around strategic asset allocation models designed to deliver long-term growth.
Where we believe the asset classes within those models have high valuations relative to other asset classes and relative to historical averages, we will reduce the proportion held (“underweight” them).
Where we believe the asset classes within the models have low valuations relative to other asset classes and relative to historical averages, we increase the proportion held (“overweight” them).
Expensive assets can become more expensive (and often do), while cheap assets can fall further before recovering (the momentum trend). We do not expect to create added value in the short term with these weightings, but we believe we can increase portfolio returns and reduce risk over three to five year periods and longer.
The chart below shows the variability and apparent randomness of annual returns in any given year. Each colour represents a different asset class, and these are listed for each of the last 14 years in order of performance. You can see that every asset class has been a good performer in some years, and poor in another. This demonstrates the difficulty in trying to pick the ‘top performer’ over such short periods.
However, if you were to invest your wealth in an equally weighted portfolio which was rebalanced annually, you would have experienced the white box returns. In this approach you never have enough of any one thing to make a killing, but neither do you have enough to be killed by your portfolio. This drives home the importance of diversification of your assets across a wide range of sectors. Our clients are not interested in gambling, they are looking for steady long term growth and this is the way to deliver it.
The chart below shows something known as the ‘PE effect’. Price Earnings multiple, or PE, is a commonly used measure for valuing shares or markets. In simple terms the PE is calculated by dividing the Share Price by Earnings per Share. A high PE number indicates that prices are high relative to the income produced, and vice versa.
It is clear that there is a pattern in the chart above. Along the X-axis we have the PE multiple (I’m showing the ‘Shiller’ PE, a relevant method for calculating PE) and along the Y-axis we have the returns achieved in the following decade. When you look at returns over ten years you can see a clear correlation between the two. The market appears to return far more over a ten year period when the starting point is one of low PE (cheap stocks) and far less when the starting point is one of high PE (expensive stocks). This is a complicated way of saying ‘buy low, sell high’.
This sounds obvious, and making good investment decisions is really quite simple when put in these terms. However, being simple isn’t the same as being easy. Firstly you need to be able to undertake the calculations necessary to make a judgement on value, and most importantly, you need to act in a rational way.
Emotions play an all-too-powerful part for most people, which is why a clearly defined investment process is so important. If that process also offers genuine diversification to limit investment risk to a tolerable level, which in turn enables an investor to keep faith when required, then you have a method that can, and does, deliver superior returns over time.
In conclusion we don’t have a clue where asset prices are going over the short term. However, we do take a view on relative valuation and believe in reversion to the mean. Using this we actively vary the asset allocation within our strategic models over time – what we call a dynamic asset allocation approach. We know that capitalism works, and that as long as there is human innovation there will be economic growth, which means that returns will be generated by real assets over the longer term.
We carry out detailed financial planning with our clients to determine what proportion of their wealth should be kept in cash for the short term and how much can be invested in assets that generate the long term growth that they require to achieve their future goals. We’ve been doing this successfully for over 20 years, and we have many happy clients who can testify as to the results.
Written by Richard Urwin, Dip PFS
Managing Director, Chesterton House Financial Planning Ltd
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