Managing Risk | Part 2: Look to the Future, Not the Past

Author: Nathan Rowader
Date: September 11, 2014
Category: Financial Planning
Tags: , , , , , ,

Last week we began a discussion on managing portfolio risk and the dangers of relying on averages. One of the core issues that make averages so ineffective in managing risk is that they rely heavily on the past. Investing is focused squarely on the future, so relying solely on past information ignores much of the useful information available to you right now. So, what sort of current information can you incorporate into the portfolio construction process?

Building a well-constructed portfolio relies on three inputs:

  • Return
  • Volatility
  • Correlation

This week, we are going to focus on a method for estimating a forecasted return. This process is a particularly good evaluation tool to determine if the timing is right for making a particular investment in a broad asset class such as large cap stocks or European stocks. It incorporates the expected growth of earnings, growth of dividends and the current valuation in a multiple of earnings (also known as the price-earnings (P/E) ratio).

Growth of earnings
A market’s earnings are basically a product of that market’s economic growth. It makes sense that as the U.S economy grows, so would the earnings of U.S. companies—and this relationship holds true in most markets. Given this fact, we can estimate future earnings growth by using nominal growth domestic product (GDP) estimates for future growth. I am biased toward GDP estimates over earnings estimates because they tend to be a bit more accurate and less subject to manipulation. However, if you feel that long-term earnings estimates are sufficient, than feel free to use those numbers in place of GDP estimates. Additionally, corporate earnings tend to slightly outpace GDP growth due to increased efficiency and the use of leverage. So, for the purpose of illustrating this process, let’s assume that the U.S. economy will grow at a rate of 4.0% over the next 10 years. Historically, earnings have grown at a rate of approximately 1.5x to 1.75x that of nominal GDP in most developed markets. Continuing our hypothetical estimate, U.S. earnings might grow at approximately 6.5% to 7.0% per year over the next 10 years.

Growth of dividends
Dividends are another important part of estimating returns. This calculation is a little easier since dividends have grown at roughly the same rate as the economy, so we can hypothetically estimate that dividends will grow at a rate of 4.0% over the next 10 years as well. I would like to point out that I am using nominal GDP because it incorporates estimates for inflation and therefore our final return estimate will not ignore the impact of inflation.

Valuation
Using our hypothetical U.S. market, let’s assume that the market is currently trading at roughly 20x earnings but that it historically trades at 15x earnings. When we calculate our final return, we will use the long-term historic multiple on estimated earnings in order to calculate the final price. This is an important step since it will discount down the rate of earnings, making the assumption that valuations will come back to the long-term average. Just like a cooking show, I did the work for you in the table below. You will see an estimate for a 10-year return on our hypothetical U.S. market along with the components used to calculate the estimate.

2014-09-blog-nrowader-managing-risk-pt2-table

A big driver of this estimate is the lower P/E ratio, and I did use a somewhat crude method of calculating P/E for the sake of this exercise. This in effect allows you to evaluate the price you are paying relative to the expected growth of an investment. At any rate, this is a good exercise and is especially useful when comparing across assets since it will help identify potentially undervalued assets. It is worth updating these forecasts on an annual basis and adjusting your portfolio accordingly. This will help you make sure that your positions are in line with current market conditions. For example, if U.S. stocks have a big sell-off, then a lower current P/E could show that expected returns have appreciably increased and you’ll want to take advantage of that.

Next week we are going to take a look at volatility and some methods for forecasting volatility.

See the rest of the series: Part 1 | Part 3 | Part 4

RISKS

Investing involves risk, including possible loss of principal. The value of any financial instruments or markets mentioned herein can fall as well as rise. Past performance does not guarantee future results.

This material is distributed for informational purposes only and should not be considered as investment advice, a recommendation of any particular security, strategy or investment product, or as an offer or solicitation with respect to the purchase or sale of any investment. Statistics, prices, estimates, forward-looking statements, and other information contained herein have been obtained from sources believed to be reliable, but no guarantee is given as to their accuracy or completeness. All expressions of opinion are subject to change without notice.

Nathan J. Rowader is a registered representative of ALPS Distributors, Inc.


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