What history teaches us about expected returns

Since the May/June 2006 market correction, investors have been wondering how to immunize a portfolio against market shocks associated with a rapid change in global sentiment. Investors often panic when the market suffers a correction and hastily decide to adjust their portfolios, often with disastrous consequences. If a portfolio is structured efficiently (i.e. well diversified), the investor should not be concerned with these events because the portfolio should deliver the expected return (for a given risk profile) over the investment time horizon, according to Tamas Kulcsar of Glacier Research.

So what can we learn from history about a portfolio's expected return?

Over ten-year periods, asset class returns vary greatly, with the median real return for some asset classes (local bonds) being negative. Even a typical SA-only balanced portfolio has delivered negative real returns over a 10-year period. Due to the low correlation between the different asset classes, the range of returns (between -3% and +12% per year) for the balanced portfolio is smaller than that for local equities and local bonds, while the median 10-year real return is 5% per annum. In other words, investors in a balanced portfolio with no foreign exposure can reasonably expect a return of inflation plus 5% over the long term.

What may be of concern to investors is that even with a 10-year time horizon, there remains the possibility of a local-only balanced portfolio delivering negative returns in real terms. How then does an investor guard against this possibility without changing the amount of risk he is exposed to?

By investing just 15% of a portfolio in foreign markets, the range of real returns narrows to between +4% and +9% (compared to -3% and +12% without foreign exposure), while the median expected real return of the portfolio increases from 5% to 6% per annum. This can be attributed to the inflation protection provided by foreign assets. When domestic inflation increases, the real yield differential between SA and the US narrows, making SA assets less attractive. This leads to increased monetary outflows from SA, putting pressure on the Rand. For a South African investor, a weaker currency increases the Rand value of foreign assets in a portfolio.

The inflation protection provided by foreign exposure also serves to lower the volatility of a portfolio because the returns of foreign assets are generally uncorrelated to the returns of local assets, partly due to the effect of exchange rate volatility, but also due to different factors driving foreign markets (e.g. developed markets are less dependant on the commodity cycle than emerging markets).

So, for investors looking to maintain the purchasing power of their investments, a small foreign allocation across all investor risk profiles is a good place to start.