Forecasting the investment weather

Prediction is very difficult…especially if it’s about the future.

Nobel prize-winning physicist Niels Bohr

Forecasting the investment weather

Forecasting ‘expected’ returns on portfolios is a little like forecasting the ‘expected’ weather in the UK.  Yet despite sensible generalisations – such as its usually sunny and warm in the summer and cold and frosty in the winter – we all know that the day-to-day, month-to-month and even year-to-year variation is high.  Given that it is holiday season, let’s start by taking a look at the weather in Newquay, Cornwall for 1st August each year, to illustrate the point.  We know that it is likely that August will be warmer than January, and if we had to describe an ‘average’ day it would probably be mainly sunny, warm, with a gentle breeze and no rain.  In reality, a wide variation from our ‘average’ sunny day exists.

Table 1: The weather in Newquay, Cornwall on 1st August, on average each year at 3pm

Data source: www.weatherspark.com.

In fact, according to the data, the average day is more likely to be cool, cloudy and windy, with a one-in-four chance of rain but with a lot of variation around this average outcome!

Forecasting the investment weather

When it comes to making estimates of future asset class returns, it is evident that there is no absolute certainty, only reasonable, informed guesses.  Expected returns are not single point estimates of guaranteed returns – absolutely not – as the chart below demonstrates.

Figure 2: Expected after-inflation return distributions of short-dated bonds and global equities

You can see that the ‘expected’ return sits within a distribution of other possible returns and the range of these potential outcomes is wider for equities than bonds. Summers are hotter than winters.  Planning alternative returns scenarios is, therefore, a critical part of building a robust financial plan.

Download the full report here: Forecasting the investment weather

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