How do how do you think your portfolio will perform over the next few years?
Do you have a figure in mind?
10% per annum?
Most people don’t have an expected return, and if they do, it’s not always based on any solid understanding of markets, but derived from averages, what their advisor thinks, or what’s being bandied about in the mainstream media.
And when economists are asked what the expected return might be, they seldom talk about the changes in the earnings yield, but give a figure based on, say, the level of the ASX 200 index.
So if the index is currently at 7,000, they’ll take a stab in the dark at a new figure, say 7,700, for a rise of 10% next year.
It tells you nothing useful, really.
For one thing, the guesses can miss by as much as 50%, even over a short time horizon, as we saw in 2008.
More pertinently, they say nothing about the expected return over the life of the investment.
You might feel a little differently if they said ‘we think the dividend yield will shrink, and you’ll pay more for it by December’.
To understand the composition of stock market returns you need to look at both the expected return and the capital gain.
Much the same way folks do with an investment property.
It’s the vital interplay between price, which is what you pay, and value, which is what you get (yes, we did steal that from Warren Buffett).
Price versus value
Let’s look at how we can see the difference between price and value (really, it’s about expected returns).
Look at the diagram below.
There’s a benefit to waiting for an opportunity to invest at a higher expected return, even if you waited for years, and even if the expected return is only a few per cent higher.
And the higher expected return (the value bit) relates directly to the price you pay.
So the less you pay the more value you get.
If you start out investing when the expected return is relatively high then you will make plenty more money over the investment’s lifetime.
That means staying focused on what the expected return on offer is.
And that is, in turn, tied to the price you pay for the investment.
The good news is that, while it’s never an exact science, there are valuation tools and measures you can use to calculate an approximate expected return (in 2020 expected returns are low in Australia and the US, but higher in some other markets).
The good news is that markets are mean reverting, and good opportunities always come around (and about every dozen years or so, on average, we tend to see amazing opportunities).
A simple example should suffice – if you pay $1 to receive a 10 cent dividend then your return is a healthy 10%.
But paying $2 for the same 10 cent dividend means you are only generating 5%.
Heaven forbid, if you pay $6 for the same stock then the yield is awful (hello US stocks).
The finance industry may still say you should expect an ‘average’ return of 8%, but this is a fallacy at such extreme prices, and perhaps even intellectually dishonest.
But, this is what happens.
In the stock market as the price rises, you are getting less in the way of dividends, and therefore the higher the market rises the lower your expected return should be.
Because you’re paying more to get the dividend.
If you’re like most people, you probably had a pretty good year in investing in 2019, with the local Aussie markets rising by about 20-25%.
So most folks in the finance field are now feeling pretty chirpy.
Markets up, so everyone’s happy.
But what does that great increase mean?
Remember what we just said – higher prices means lower returns.
Ah yes, you say, but I get the capital gains as well.
Well, yes…if you sell.
If you don’t sell and you’re a buy and hold investor (as you may be in your superannuation fund account), then the capital gain is largely irrelevant since you’re a long term holder – so the capital gain looks nice on paper, but what you really want is to generate a great return on your initial investment.
Thus, lower prices are better, not higher prices.
In fact, it makes complete sense to want lower starting prices because you get a greater expected return.
When markets are bullish and heading north, many forget the shrinking expected return and get too excited about the capital gain, and so the cycle turns.
Mean reversion applies
We know that markets mean revert and so at some stage in the future the market will probably decline (in capital value).
But somewhat paradoxically you should rejoice because this means you’re being offered a cheaper price for the value that you will get (usually expressed via the dividend).
In order to do that, some investors will be better off selling some of their stocks at the current high prices, placing the capital gain in the cash tin for a while, and awaiting the next opportunity when Mr. Market offers you a better expected return.
‘Market timing doesn’t work’ you may say?
Well, sort of – it’s not about picking exact months for markets to peak or decline.
It means simply seeking opportunities to make every dollar work as hard for you as possible at higher rates of return.
You can think of your hard-earned dollars as employees going out to work for you.
It’s fine if you only want them to earn 4% each year, but it’s much more lucrative if they’re expecting to earn 12-20%.
After all, this is what the world’s best investors do – Warren Buffett, George Soros, and others – buy the cheap, and sell the expensive.
The diagram above shows that even compounding at a slightly higher rate delivers excellent returns over a shorter period because you’re getting a good deal of value via paying a cheaper price.
So when it comes to markets don’t just check what the capital gain is, because that’s only useful if you sell and collect the gain.
If you’re planning to be in the markets for a long time, it’s wise to focus on both the price and the value you are receiving.
Check the expected return (e.g. what the earnings yield or dividend return is) and use the CAPE ratio to figure out how markets might fare over the next 10-20 years.
If the return is shrinking then smart investors think about rebalancing some of their portfolio into cash to await the next offer that comes around with higher expected returns.
It takes a bit of patience, but history says they’ll be rewarded.