 |
| 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):
|
| |
|
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.
|
