How Much Return?

Your expectation of returns is fundamental to your judgement of where to invest, how much risk to undertake and how much to pay for product management


  • If you invest in equities, what return are you expecting?
  • If you invest in corporate bonds, what return are you expecting?
  • If you invest in gilts, what return are you expecting?
  • Do you really have to understand this stuff?

Yes you do! If you duck this:

  • you will never be able to make informed judgements about your savings strategy, and
  • you will always be putty in the hands of product providers.

Homework

You may want to refresh your memory about the difference between 'real' and 'nominal' (or 'money') returns. See 'Real Returns '.

Also understand the principle of the trade-off between risk and return. It is convenient to think of the return on a particular investment as the sum of a risk-free return and a risk premium. The return on government bonds ('gilts') is usually taken as the risk free return. High risk investments attract high risk premiums. See 'Risk Premiums'.

What about the future?

Well, who knows? But we can get some insight from the pronouncements of the experts.

All pension funds need forecasts of future returns. So, pick up the annual report of any major company with a pension fund and you can see the assumptions for future returns for different asset classes. They all have much the same pattern. Here's one (August 2005 - sorry, but this just an example and these numbers change all the time):

    Real Return Inflation Nominal Return   Premium over Gilts
  Gilts
1.7%
2.8%
4.5%
 
-
  Corporate Bonds
2.4%
2.8%
5.2%
 
0.7%
  Commodities
2.7%
2.8%
5.5%
 
1.0%
  Hedge Funds
3.8%
2.8%
6.6%
 
2.1%
  Commercial Property
4.2%
2.8%
7.0%
 
2.5%
  UK Equities (Shares)
5.2%
2.8%
8.0%
 
3.5%
  Overseas Equities
5.2%
2.8%
8.0%
 
3.5%

 

Warning! The only thing certain about a forecast is that it will be wrong.

The purpose of this table is to give you some insight on expectations. And that is to help you make asset allocation decisions. How much extra return can you expect for taking on extra risk, and is it worth it to you?

Product charges and risk premiums

The table shows a forecast equity risk premium is 3.5% per annum. That may seem small, but you know what a big difference compounding makes.

Now:

  • if your personal savings comprise the usual mess of investment products, and
  • you are paying the odd % to a fund manager here and the odd % to a wrap manager there and the odd % to an adviser somewhere else, and
  • each of those gentlemen is paying brokers and other middlemen in ways you may never see because it comes out of your fund returns,

.........then it does not take too long for these costs to get to 3 or 4%, which is the equity risk premium.

In which case, why bother with the products? Better to put your money in risk-free cash. More generally, the level of charges in a financial product needs to be sensible relative to the risk premiums of the investments underlying the product. The table above, while just one example among thousands of similar tables, shows you the sort of risk premiums you might expect.

Too many investors take on investment risk and just give the risk premium away to middlemen.

 

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