Forecasting investment return

Of course, nobody knows what future returns will actually be.

But you do need to have some idea of how much your portfolio will increase by, either so you can add more money to get to your target during accumulation, or so you can adjust spend during drawdown.

Most people pluck a single number out the air based on historical returns from similar assets. Say, 9%pa for S&P or 6%pa for FTSE100. This is not a terrible approach, but it masks the fundamentals of what’s actually going on and doesn’t really allow you to match your current portfolio size to future outflows to support your lifestyle.

A more robust approach is to consider the long term average difference between investment return and inflation for the market you are invested in. This difference is surprisingly stable, even during long periods of volatility. This is called the “real return” per annum.

For my own modelling, I assume +2%pa average real return over the next 40 years. This means I expected the average annual investment return to be two percentage points higher than the average annual inflation rate.

Note that my actual average real return over the last 25 years has been +3.1%pa. This might not sound a lot, but it’s 50% higher! But I stick to the 2% number in modelling to be conservative.

Once you have a annual real return that you are comfortable matches your investment strategy, then you are good to go. The magic of this approach is about to reveal itself.

You now need to pick a number for the average inflation rate in the future. Again, like investment return, no-one knows the future and it could be anything … 3%, 5% … who knows?

But … here is the incredibly important insight … it doesn’t matter!

Let’s suppose you choose +2% as your projected real rate of return.

If you pick 3% as your inflation rate, then you would use 5% as the investment return in your model.

If you pick 5% as your inflation rate, then you would use 7% as the investment return in your model.

But it really doesn’t matter. The mathematics will produce pretty much the same result either way.

This is because, for forecasting purposes, the absolute value of your projected fund in future years is irrelevant. The only thing that matters is how many years your current fund will support your current lifestyle for in real terms.

And the best way to do that is to have a clear link between your investment strategy and the long term, real average annual return.

Read more on this topic . . .


Disclaimer

I am not your financial adviser.

The information in this post relates to my financial journey. It may or may not be relevant to your own. You need to make your own decisions on your own financial strategy.

Do not buy or sell anything based solely on what you read.