How Predictable Are Future Share Returns?
Even if you don’t own shares in your own name, you can be certain that your superannuation fund has invested in them on your behalf with allocations of around 50 per cent common and some as high as 70 per cent.
So, if they make up the bulk of your retirement investment, wouldn’t it be good to be able to predict what they’ll earn?
Fascinating new research casts a cloud over the predictability of future equity earnings. Evidence suggests sharemarket returns are becoming more volatile and less predictable.
The research was commissioned by Challenger and written by Bianchi, Drew and Walk and assessed the equity risk premium (ERP), that is the extra return of shares over and above risk free bonds. They examined the historical equity risk premium using the well-known and widely cited Dimson, Marsh and Staunton database covering sharemarket returns of 19 countries from 1900 until 2014.
The good news is that the Australian sharemarket was the second best performing over the 115 year period earning real, inflation adjusted returns of 7.3 per cent, behind South Africa with 7.4 per cent. Further, our market showed one of the lowest standard deviations – a measure of volatility of 18 per cent.
However, the research also showed that investors must experience ‘potential large annual losses’ as evidenced by highest loss years of –34 per cent for Canada and -67 per cent in Ireland in 2008. Australia’s worst loss year also in 2008 was -44 per cent.
A key finding of the study was that there was roughly a one in five chance that a 20 year historical equity return would be lower than the risk free return in that period.
In the Australian analysis, the average ERP to bonds over the last 90 years was 5.6 per cent but ranged from -1.5 per cent to a very high 12.9 per cent in the late 1960s. The most recent 20 year period showed a declining ERP, generally well below the 5.6 per cent average.
Surprisingly, average returns over the last 20 years for Australian shares were 9.9 percent and risk free bonds 8.9 per cent.
Key determinants of the changing equity risk premium
- Market imperfections in pricing – which generally were thought to have declined given better technology and thus less human errors.
- Risk aversion due to an aging demographic, as investors age, they generally want to reduce risk, pushing the ERP higher.
- Economic risk – related to the general health of the economy. The ERP is lower with predictable inflation, sound regulation and relatively stable interest rates and economic growth versus an economy where the variables are less predictable.
- Catastrophic risk – extreme risk events which can cause equity valuations to decline suddenly or even crash. Research from 24 countries over more than 100 years showed that they occurred on average every six years.
If investors and superannuation funds have high allocations to shares, the big unknown is what the ERP is going to deliver in future. Historic returns are not reliable in predicting the future and this research suggests the ERP is changing.
Implications for investors
It is all a matter of balance and being able to withstand volatility in earnings and large potential losses in your portfolio.
Rather than look to a single asset class in which to invest, particularly if it’s to fund your retirement, diversify your investments and include a range of investments with known outcomes such as bonds and annuities and consider dynamic strategies.
If only we had a crystal ball that could offer us some comfort regarding the returns on shares. So many investors rely on them. Fascinating new research casts a cloud over the predictability of future equity earnings. Evidence suggests sharemarket returns are becoming more volatile and less predictable.
Elizabeth Moran is a director of education and fixed income at Sydney-based bond broker, FIIG Securities.
She is a specialist on the bond market and regularly presents at conferences across Australia. Elizabeth is the editor of FIIG's weekly newsletter The Wire and is the is the author of "The Australian Guide to Fixed Income".