Expected Returns for Shares Explained

What expected returns you are likely to receive from investing in shares isn’t an exact science by any means, but that doesn’t mean we don’t need them for planning purposes.

On the contrary, we need some idea of what we might get so that we can decide how much money to save.

Whenever I ask anybody about stock market expected returns I can pretty much divide the answers into three groups. Those who haven’t a clue, those who say 10% and those who go off whatever fund they themselves invest in.

If you fit in the first group, then this article’s for you!

The 10% group are going off historic averages, and that’s because both the UK and US stock markets have averaged 10% annually in the past. When you knock off inflation the US is doing a bit better than the UK. Real returns i.e. after inflation are about 5% in the UK and almost 7% in the US.

The expected returns suggested by those in the final group are determined by the recent returns of whatever fund they’ve been investing in, and boy do they vary!

Hot funds

If they have been lucky enough to invest in one of the hot funds of the moment like Fundsmith Equity or Lindsell Train Global Equity they expect +20% going forward because that’s what they’ve been getting for the last three years.

Alternatively, if they’ve been unlucky enough to have invested in a fund like Woodford Equity Income they expect -5.89% because unfortunately that’s what they got over the last three years.

So on the face of it expected returns vary between -5.89% and 20% depending on which fund you are investing in.

But contrary to popular belief sticking your hard earned savings into a fund that has been doing well recently, might not be such a wise move.

Reversion to the mean

In fact, for all those unlucky enough to have invested in Woodford Equity Income hopefully there is some light at the end of the tunnel because recent returns are anything but a reliable indicator of future returns.

The late John Bogle, founder of Vanguard and the man responsible for the first index fund, in his book Common Sense on Mutual Funds talks about a “kind of law of gravity in the stock market, through which returns mysteriously seem to be drawn to norms of one kind or another over time.”

Bogle acknowledges that there are some special funds out there that may out-perform for 10 years or more, but that over the very long run they nearly always come back down to earth and end up producing returns equivalent to the market average.

Similarly, funds that underperform may end up rising up to the market average too.

In other words, all securities should produce returns near the average of the wider market over time. So according to Bogle in all likelihood it’s only a matter of time before funds like Fundsmith Equity and Lindsell Train stop out performing and funds like Woodford Equity Income stop underperforming.

Active vs passive management

As a result, it makes sense to invest in low cost funds that track as wider portion of the market as possible. Why bother paying high fees for active managers when in all likelihood over time they are just going to achieve returns equivalent to the wider market minus their fees.

And it makes a lot of sense. In reality these active managers have hundreds of billions of dollars of assets under management. In effect, they are the market or the average of them is the market. This means over any time period half of them are going to do better than the other half and that’s before we’ve taken fees into account.

Unfortunately for them, once the fees are knocked off, a good chunk of the ones that would have outperformed the market end up underperforming and this is backed up by piles of empirical evidence.

SPIVA

Every year S&P Dow Jones Indices release their SPIVA Year-End reports, where they compare how their indices compare to active managers. All the biggest hedge funds and mutual funds are in the US, so it figures that if anybody can beat the indices, the Americans can, but it seems they can’t. Here’s what S&P Dow Jones have to say:

Over the 15-year investment horizon, 92.33% of large-cap managers, 94.81% of mid-cap managers, and 95.73% of small-cap managers failed to outperform on a relative basis.

SPIVA

So basically over the fifteen years covered only about one in twenty funds taking an active investing approach have beaten their corresponding index funds. Whichever way you frame it, that doesn’t look good for active investing.

But then again, one firm out of every twenty does beat the market, so you could just go with that one. Lindsell Train or Fundsmith perhaps. The thing is, whilst nobody can argue that these funds have out performed in the past, you’ve no guarantee that these funds are going to continue to their exceptional performance.

In fact in a previous life, the now struggling Neil Woodford built his reputation during 26 years at Invesco Perpetual where he beat the market for a quarter of a century! If Woodford’s funds can start to underperform the market then anybody’s can.

Here’s what Ryan Poirier, senior analyst at S&P Dow Jones Indices, has this to say on this matter:

If you have an active manager who beats the index one year, the chance is less than a coin flip that the manager will beat the index again next year.

Ryan Poirier, senior analyst at S&P Dow Jones Indices

The Fundsmiths and Lindsell Trains of this world may be the 1 in 20 that continue to beat the market for 15 years straight, but the likelihood is they won’t be.

In fact, the overwhelming evidence suggests choosing which funds are going to do well in the future is just as difficult as choosing individual companies to invest in.

With all that said, some investors will still be confident that they can find a fund manager that outperforms the market, and others will be just as confident that they can beat the market by picking individual shares themselves.

Going with the market

However, for the vast majority of investors the overwhelming evidence is clear that they are likely to do better by taking a passive approach to investing. In fact, even the greatest investor of them all agrees with this idea. Warren Buffett himself recommends choosing an index fund:

It will do better on balance than what they (investors) will get if they go to professionals, because the professionals, after fees, don’t know how to get a better result.

Warren Buffett

Let’s be clear here. Buffett’s not saying markets can’t be beaten. Without doubt, they can. Fundsmith, Lindsell Train, Woodford and Buffett himself are all proof of that.

Instead what he’s hinting at, is that it’s extremely difficult to beat the market yourself, and it’s just as hard to find somebody who can beat the market for you in the future.

But that doesn’t mean you shouldn’t invest. On the contrary, if history is anything to go buy it doesn’t matter that you can’t beat the market because the market has been extremely generous. Just invest in the market itself and you should do just fine.

If you can’t beat it, join it!

Market Capitalization

By market, we are talking about all the stocks available in proportion to their share of global stock market capitalization.

Market capitalization is calculated by multiplying the total number of shares of a company by its share price. For example a company with 10 million shares selling at $100 a share would have a market cap of $1 billion. Add up the companies from a particular country and you’ve got the market capitalization of that country.

So big companies take up a larger share of the market, and then countries with bigger companies take up a larger share of the world.

Of course investing in every stock isn’t practical but investing in a large chunk of the market is easily done these days through index trackers.

For example, the FTSE All-World Index covers 90-95% of the investable market capitalisation. There are funds that track this index cheaply such as Vanguard’s FTSE All World UCITS ETF which has ongoing charges of 0.25%.

So what are the expected returns for this global stock market?

Well, there are lots of different sources of expected returns, and they provide a vast range of different numbers. This section takes a look at some of the most well respected sources of expected returns.

Vanguard market outlook 2019 projected annual returns for global shares

Vanguard, the largest provider of mutual funds in the world, and most importantly one of the most trustworthy sources of information in the business, project very low returns for the next decade.

In their Economic and Market Outlook for 2019, the company offers some sobering projected 10 year nominal investment returns for global shares.

5th Percentile	Median	95th Percentile
-2.6%	4.1%	11.3%

Vanguard Market Outlook 2019 Projected Annual Returns for Global Shares

It’s a pretty wide range. If your in the bottom 5th percentile you could lose -2.6% a year, or if you are in the top 95th percentile you could make 11.3% per year. But most of us are going to sit in the the middle, so it’s more likely that we’ll make around 4.1% per year.

I’m sure it wouldn’t have even crossed the ten percenters or Fundsmith and Lindsell train investors’ minds that 4.1% returns could be on the horizon for the next decade.

In fact, I’m sure many investors will be disappointed with that figure. However, 4% will still grow your wealth and though ten years sounds like a long time, it’s nothing when it comes to investing.

These days people are expecting to live into their nineties and working into their seventies, so even if you don’t start saving until your forties you’ve probably got an investment lifetime of 30 years to work for you.

The next 10 years might be 4%, but the subsequent decades may be more.

The Gordon Equation

As an alternative to Vanguard, you could try to come to some expected returns yourself using the Gordon Equation.

Some people might be put off by the word equation, but don’t be. It isn’t complicated at all.

The Gordon Equation crops up all over the place. Bill Bernstein includes it in his great book The Investor’s Manifesto.

It is calculated as follows:

Expected real return = Current Dividend Yield + Real Earnings Growth Rate

So to estimate your expected real return you just add a couple of numbers together and hey presto!

You should be able to get the current dividend yield for whatever broad equity market index you are interested in straight off the relevant fund’s website.

A quick trip to Vanguard UK shows the current dividend for their global share index (FTSE All World UCITS ETF) is 2.06%. All we need to do is add this value to the growth rate. Bernstein suggests 1.32% as a real earnings growth rate.

In truth, this number is for the US, but other sources for different places seem to be in a similar ball park, so many people go with that as a one size fits all.

So all you do is add this 1.32% to the dividend yield of 2.06% and you are good to go. That’s an expected return of 3.38%.

Note this is a real return, so a return on top of inflation, whereas the Vanguard return is a nominal return so that includes inflation.

Nobody knows for sure what inflation rates are coming, but according to Statista global inflation has averaged about 3% over the last 5 years.

In the absence of anything better, if we assume that this will continue, then 3% inflation added to 3.38% gives provides expected returns of 6.38%, which I’ll round to 6.4%, so a little higher than Vanguard’s expected returns.

Lars Kroijer

Another view is put forward by Lars Kroijer. In his book Investing Demystified he suggests that a safe assumption for long term real returns can be based on long term historic returns.

Based on this he comes up with 4-5% for global shares. Taking the mid point as 4.5% and adding on the 3% inflation gives us 7.5% over the very long term.

Credit Suisse

Credit Suisse produce an Investment Returns Yearbook year. The 2019 edition predicts 3.5% long term for global shares over inflation.

And that’s 6.5% when we add in our inflation, which is pretty consistent with the Gordon Formula.

The bottom line

So that’s four different sources and four different numbers (although two are very similar). The table below summarizes these expected returns.

Type	Vanguard	Gordon Formula	Lars Kroijer	Credit Suisse
Real Return	1	3.4	4.5	3.5
Nominal Return	4	6.4	7.5	6.5

Assumptions

It is worth reiterating that the 3% inflation is an assumption. A reasonable assumption it maybe, but only time will tell if it is an accurate one.

Because of this, except for Vanguard who actually provided nominal returns the real returns are likely to be more accurate. That said when most people talk about returns they are talking about nominal returns. That’s what the ten percenters and the Fundsmith and Lindsell Train investors are talking about anyway.

All those guys that are expecting 10% are probably going to be a little disappointed with those figures, but all except Vanguard are in a similar ballpark.

Remember, historic inflation has been 5% in the UK, meaning the real return for stocks has been about 5%. That’s in line with Kroijer’s expected returns and not too far above the Gordon Formula and Credit Suisse numbers.

However, no matter which way you frame it, if mean revision kicks into action and those outperforming funds like Fundsmith and Lindsell Train start performing like the wider market the investors in those funds are going to be severely disappointed.

But in all reality, even Vanguard’s 4% rate of return would grow wealth quite respectably. £10,000 compounding at 4% annually over 25 years would give you £26,658.36. The more you started with and the more you added along the way the more you’ll have.

Personally, I would always edge on the conservative side. If I assume 4% and make plans accordingly and then end up getting 20% per year, I’m going to be a lot happier than planning with 20% and getting 4%.

Plan for the worst and hope for the best.