Most people understand that the returns of growth investments (i.e. shares and property) fluctuate considerably. If they didn’t prior to the Global Financial Crisis, they most certainly have a better grasp of that now.
But most don’t really have a good understanding of the potential range of variation of returns, without anything particularly unusual happening. And nor do they appreciate how dramatically the pattern of returns can affect long term wealth outcomes.
We use the Australian share market experience of the 25 years to December 2009 to shed some light.
The road to wealth is rocky …
The chart below that shows the growth of a $1 invested in the Australian share market (as represented by the S&P/ASX300) from December 1984 to December 2009.
While the average return over the 25 year period was 8.30% p.a. after inflation, growth fluctuated considerably around the dashed line. This line represents what would have occurred if the share market rose at a steady 8.30% each year.
To highlight how different to a nice steady path the actual experience was, the following chart shows the pattern of monthly returns:
The returns appear almost random, with some very large fluctuations around the average. The chart below plots these monthly returns on a bar chart or histogram to identify how they are clustered.
It reveals that they are distributed in an approximately bell shaped (or “normal”) pattern, as represented by the red line. Of course, there are some clear and very significant divergences from normality, with the October 1987 “crash” accounting for the outlier that sits at (-)42%.
But if the assumption is made that the returns are distributed as suggested by the red line, then standard deviation (“SD”) is a measure of their variation. At 4.82% a month, it implies that in any month returns had a 68% chance of lying between (-)4.0% and (+)5.6%. It also says that there was a 32% chance that the returns could be outside what is already a broad range.
So, share market returns are extremely volatile and have no apparent short term pattern i.e. essentially random.
A message to take from this is that in trying to predict future investment returns, the past is highly unlikely to provide any guide to the future! Even if you knew for certain that the returns came from the distribution represented by the red line in the chart above.
To show this, the charts below show two groups of ten possible 25 year share market futures that have been randomly generated from the same distribution that roughly describes Australian share market returns for the period from 1984-2009. These “futures” are compared with the 1984-2009 actual.
Ten possible futures …
… and ten more
The “futures” vary from significantly above to significantly below the past. They suggest virtually anything can and will happen.
However, to provide a better feel for the range of potential outcomes, we generated a 1,000 possible 25 year “futures” (or simulations) by randomly selecting annual returns from the normal curve shown above. The results are presented in the following chart:
It indicates that 5% of the simulated growth paths exceeded the “95th Percentile”, the green line, that itself was much higher than the actual experience of 1984-2009.
The final year outcome of the “median” or middle simulation, indicated by the purple line, was approximately consistent with the 1984-2009 actual experience.
Finally, 5% of the simulations were worse than the already nearly flat “5th Percentile”, represented by the orange line. It indicates the possibility of almost zero real growth in the share market for 25 years.
This may sound unrealistic. But the actual experience of the Japanese stock market has been much worse over the past 20 years, while the US stock market (i.e. S&P500), as at 31 December 2009, was still 30% below its March 2000 peak.
So wealth management is, perhaps, riskier than you thought …
Some key messages for wealth management that emerge include:
- accurately forecasting investment returns over an extended period is an impossible task;
- even if you could correctly predict the average return for that period, there are an infinite
number of paths consistent with that average. Depending on the timing of your cash flows, your wealth outcomes could vary dramatically; and
- the pattern of past investment returns is unlikely to be much of a guide to future investment returns.
How can you plan in a world of such uncertainty i.e. the real world?
It sounds like your wealth position at some distant point in the future is essentially a lottery. Well, to a large extent it is, but there is a lot you can do to ensure that, despite the uncertainties, you give yourself the best chance of achieving your lifestyle objectives.
This article is an edited excerpt of Chapter 6 from our eBook, “Wealth Management: A risky business”. Sign up to obtain a free copy of the eBook plus monthly notification of articles recently posted to our “Smart Decisions Blog”.