The Heart of Intelligent Investing: Estimating Expected Return and Risk

Nirvana for investing is getting tomorrow’s news today. Impossible, of course, which leaves strategic-minded investors to search for the next best thing. That boils down to hard work.

Estimating expected return and risk is at the heart of intelligent investing. We still can’t peer into the future with a high degree of certainty, but thanks to decades of inquiry in the realm of financial economics there’s a modestly clearer picture of how the markets behave and what that means for asset pricing.

Explaining the details would take more than a few posts here, to put it mildly. Indeed, fleshing out the finer points is one of the reasons for launching The Beta Investment Report, which discusses new and existing research and updates the implications for multi-asset class investing on a monthly basis.

Meantime, consider a few examples of how the markets drop clues for estimating risk premia. Take the Treasury yield curve, which has gone negative ahead of every recession for the last 40 years, including the current downturn that began in December 2007, as per NBER. For obvious, and not-so-obvious reasons, that’s a crucial measure for estimating the equity performance over the medium- and long-term horizons. Granted, it’s not a timely indicator in the sense that recession may not arrive for a year or more after the fact. Nor can the indicator be blindly trusted to be a timeless, unerring metric of what’s coming. There’s always the chance that it could be wrong the next time. But there’s quite a bit of economic research that suggests we should pay close attention to yield curves.

Nonetheless, the yield curve can’t be used in isolation. We need to monitor and analyze other metrics too, with an emphasis on considering a range of data series that aren’t closely related. For instance, the dividend yield on the overall stock market fits the bill. It too has a powerful economic basis for dropping clues about the future, economists advise, in this case offering a more direct estimate of the expected equity market return. Alas, as a consistently timely metric over the decades, trailing dividend yield looks marginal as a signal of the future. But that’s not the challenge it appears to be for a number of reasons.

Economists are only just beginning to piece together how the predictive abilities of any one factor fluctuate through time, partly in sympathy with the ebb and flow of the business cycle. In other words, different predictors offer a better view of the future only at certain times vs. other predictors. The implication: intelligently combining an array of predictors is more productive than any one factor suggests. The evidence that this is more than wishful thinking is becoming clear in the empirical research, as we discuss semi-regularly in The Beta Investment Report.

Consider, for instance, that dividend yield tends to offer a more robust outlook for returns during times of broad economic stress vs. during periods of economic expansion. Meanwhile, the yield curve is more productive as a tool for estimating the business cycle at times when the curve inverts. Recognizing those points and putting these two metrics together, then, offers a deeper, richer level of context on a strategic basis than either metric does alone. Of course, we need more than these two variables, but the basic idea is that more is better.

Let’s be clear: Piecing together the limited evidence for what’s coming isn’t easy, nor is it necessarily intuitive. Even worse, it doesn’t offer a sure bet, which is one reason for owning a broad array of asset classes that deviate only cautiously and intelligently from the market-value weights On the other hand, estimating returns based on the economic logic offers more promise for projecting returns vs. a naïve extrapolation of the long-term historical record.

Market behavior and asset pricing are still mysterious in many respects, but we’re learning some of Mr. Market’s secrets over time. To be sure, the old man doesn’t tell us much; in fact, he’s reluctant to tell us anything. The good news is that a few tidbits have spilled out over the decades.

About James Picerno 894 Articles

James Picerno is a financial journalist who has been writing about finance and investment theory for more than twenty years. He writes for trade magazines read by financial professionals and financial advisers.

Over the years, he’s written for the Wall Street Journal, Barron’s, Bloomberg, Dow Jones, Reuters.

Visit: The Capital Spectator

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