The Pitfalls of Return Forecasting

Coverage of the 2015 Risk Management Conference

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cyrstal ballInvestors rely on forecasting to help them make investment decisions. But “many of the metrics that investors use to predict returns have been shown to have very poor predictive powers,” said Remi Ajewole, multi-asset fund manager with Schroders.

She argued that it’s challenging to use valuations as a signal for short-term returns. “It’s an opinion, not a fact…you’re prone to forecast error,” she noted. Also, the distribution of short- term versus long-term returns varies over time.

“What we have to do is take a step back and revisit the fundamental case for investing…the risk/return tradeoff,” Ajewole said. But this is difficult since, of course, one can’t know in advance what the risks are going to be.

“The reality is that when you invest in riskier assets, you expect to earn a higher return. But you’re exposing yourself to a wider range of return outcomes,” she explained.

Rethinking portfolio construction 

Does this mean investors are wrong to try to forecast a single return estimate? “There are a variety of outcomes, so why should we limit ourselves to just one?” Ajewole asked.

If we agree it’s difficult to forecast returns, then we really need to think about risk tolerance when constructing portfolios, she said. For example, if you’re willing to accept more risk, are you also willing to expose your portfolio to higher levels of forecasting error?

“It’s about considering how confident you are in your ability to forecast returns,” Ajewole explained. If you don’t want the risk of forecasting error, you might want to consider techniques that aren’t so sensitive to it, she suggested.

What’s the alternative? Rather than trying to determine what the actual returns will be, Ajewole proposes focusing on whether they will be positive, negative or neutral. “If you focus on direction, the odds are in your favour.”

Instead of trying to gauge expected returns, she suggests using asset class ranks (1 being most favoured, 4 being least favoured). Then, use your portfolio construction tool to maximize these ranks and make your portfolio construction more scientific.

“It allows you to move away from relying on a point estimate,” she explained. “It releases you from being so sensitive to forecast error.”

Ajewole also advises stress testing—determining how much your plan can stand to lose—and dividing the portfolio into two blocks: core assets (the “good” portfolio) and hedges (the “bad” portfolio). Then optimize both blocks.

“We need to think in terms of multi-dimensional space,” she added. “And when you think that way, it opens up the universe for you.”

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