Sadly, investors lost one of their greatest advocates recently, when Jack Bogle, the founder of Vanguard and a pioneer of the index investing movement, passed away. Jack’s legacy is 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.
Unrealistic expectations for stable returns
While in the real world, the idea of efficient markets is more a useful framework than an established investing law, over the long run, market returns dominate the outcomes of most traditional buy-and-hold investment strategies. For a typical long-only stock portfolio, market returns will usually explain at least 80% of total portfolio return over time. Mr Bogle identified that the investment returns in the traditional mutual funds could be replicated for a fraction of the cost than was being charged.
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 beat to justify their existence. Perhaps more important, Mr Bogle’s crusade 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.
The idea that beating the market should be thought of as hard and unpredictable is a vitally important concept with a number of significant implications.
Consider how many investors set 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 Schroders found that 41% of Australian investors expected annualised returns of over 10% from their whole portfolio over the following five years. Similarly, the most recent ASX Australian Investor Survey (prepared by Deloitte Access Economics) showed that the average return expectation for an Australian investor was 9%. Even more revealing are the acceptable risk tolerances. Fully 67% of Australian investors surveyed by the ASX held a risk appetite that accepted only ‘guaranteed’ or ‘stable’ returns. Indeed, 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 on investment returns
Humans are emotional actors. When investing, we are prone to behavioural biases such as over-confidence and trend-chasing. The highly-ambitious double digit return expectations could only apply to investors willing to bear the risks in 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.
Determining reasonable ‘long run’ return assumptions for an asset class is an inherently problematic exercise. 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.
It is a particularly optimistic investor who uses a long-run return expectation of greater than 10%, even for a portfolio consisting only of shares. With cash rates for retail investors at only 2%, such returns are herculean for investors with a low risk tolerance (ie guaranteed or stable returns). Under the efficient market paradigm, it is impossible to outperform the ‘market’ while taking significantly less risk than the market.
We 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 to the GFC, 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 returns are 2%. 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.
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 LICs and ETFs arriving onto the ASX. There is a limit however to what investors should let themselves expect as 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 six 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 willingly accept from time to time, ask yourself some questions about what you should realistically expect and the risks you are willing to take to get there.
Judging by the survey findings, the average investor today expects high returns from a low growth, low interest rate world. 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.