How we forecast potential investment returns

Stephen Desmond
on

If you’re creating an investment portfolio or looking to invest in a fund, the chances are the first thing you want to know is what kind of returns you’re likely to get.

This isn’t as simple as projecting a single number and investment returns can’t be guaranteed, of course. But understanding the likelihood of each possible outcome and how it has been calculated by your investment manager can really help inform your decision-making – in particular, the level of risk you’re willing to take and how long you want to invest for.

forecasting projected returns

At Nutmeg we have designed a suite of free interactive portfolio tools. When you come to the site you can create a sample portfolio in just a few minutes by entering a lump sum, monthly contribution, risk level from 1 to 10 and a timeframe for their investment. We’ll then show you the kind of portfolio we could build and manage for you based on the information entered, and a series of possible returns.

Nutmeg sample portfolio - projected returns

How we calculate projected returns
The investment projections we show are never a guaranteed predictor of future performance, of course. They are there to give you context and help you make decisions about the kind of portfolio that might best suit your investment goals.

Using long-term historical data, we calculate the expected average returns for each portfolio and then a spread of likely outcomes either side of that average.

These projections are based on the estimated returns for a portfolio of equities and government bonds, in different percentages, depending on your chosen risk level. In general, the higher the risk of a portfolio the greater the proportion of equities – both in the UK and overseas – and so a higher level of expected return. In the example above, a typical risk model 6 portfolio at Nutmeg would contain around 60% equities and 35% bonds.

Medium-risk portfolio asset allocation with Nutmeg

Fees, tax and dividends

Our investment projections are net returns after subtracting an annual fee of 1.0% (including VAT), as this is our management fee for portfolio contributions up to £25,000. We also assume here that income is reinvested and that any monthly contributions are maintained. The forecasted returns do not include the effects of tax on your investment income, tax on capital gains, of changing your risk profile, or of future changes to our investment strategy.

It’s also important to remember that investments can lose value as well as gain, especially when viewed over a short time period, and the investment journey can feel quite bumpy and unsettling if you’re not prepared for the potential volatility. So, long-term projected returns are unlikely to be consistent from month to month or year to year.

Expected returns from bonds and equities

For UK equities, we currently project the long-term (10 years) average annual return to be 7.3%, and for international equities, 7.4%. These estimates are based on historic annual real returns – that is, actual returns minus retail price inflation – from 1900 to 2012. We also make an assumption that inflation will average 2.5% over the long term in the UK, which uses the Retail Price Index as our barometer, and 2.0% globally, which uses the US Consumer Price Index.

For bonds, we currently use a range of measures to arrive at an estimate of long-term government bond returns, including:

• The five and ten-years ahead rates implied in the UK government bond yield curve for both conventional and index-linked bonds
• Long-term nominal GDP growth
• The real return delivered from gilts since 1900.

From these measures we arrive at a central projection of a 3.5% return from all gilts and 2.5% for under five-year UK gilts. These are expected long-term average returns and should not be interpreted as indicating that this return may be achieved in any one year.

Probability factors

The fan charts in our portfolio tools show the probabilities of achieving various possible outcomes over different time periods. These are also based on the historic volatility of each investment type – or, asset class – since 1986.

We display 10 fan charts, one for each of our 10 portfolio models – with 5 lines of projections on each, for a forecast period up to 600 month:
• expected return
• 95% probability
• 80% probability
• 20% probability
• 5% probability

Reliable data sources

We always use robust, industry-standard data sources at Nutmeg. Here’s a little more detail about the exact sources we analyse to project different types of investment returns…

To calculate the expected return on UK equities, our data source for 1987-2012 is the FTSE-All Share total return index (source: Macrobond database). Prior to 1987 returns are calculated using data from Dimson E., Marsh P. and Staunton M. “Triumph of the Optimists: 101 Years of Global Investment Returns” while the Retail Price Index (source: Macrobond database) is used as the measure of inflation. The projected nominal annual return equates to the real return (4.8%) plus expected inflation (2.5%), so.7.3%.

To calculate the expected return on global equities, we look at the returns on the MSCI World index from 1970-1987 and MSCI All Country World from 1987-2012 (source: Macrobond database). For the 1900-1970 period we use the returns from US equities as a proxy for global equity returns, from Dimson E., Marsh P. and Staunton M. “Triumph of the Optimists: 101 Years of Global Investment Returns. The projected returns are adjusted for inflation using the US consumer price index (source: Macrobond database).

The long-term real return from global equities was 5.4% after inflation. With US inflation projected to average 2.0%, the nominal return is currently projected to be 7.4%.

For bonds, our projection of 3.5% returns for long-term nominal government bonds is lower than would be suggested by the forward curve. However, given the likelihood that long-term bond yields are lower than in the previous decade, we believe that it is prudent to adopt a 3.5% return assumption. The rate is in line with nominal GDP growth over the past 10 years.

Moreover, the real yield assumption is broadly in line with the inflation-adjusted return delivered from bonds over 1900-2012 (+0.8% over RPI inflation, from Dimson E., Marsh P. and Staunton M. “Triumph of the Optimists: 101 Years of Global Investment Returns”).

Risk warning

As with all investing, your capital is at risk.

Stephen Desmond

Stephen Desmond

Stephen regularly contributes to the Nutmegonomics blog - writing about investment and personal finance.

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