Predicting the Future

In previous articles, we have been looking at the inputs to and outcomes from an investment strategy, and have identified the return on an investment asset, generally made up of some combination of growth and yield, as a key measure of the performance of that asset.

We are able to obtain information on the recent growth and current yield of different investment assets with varying degrees of accuracy.  For example, a bank term deposit may offer a total return of about 4%, made up entirely of a 4% interest payment ( yield ).  A managed fund or a superannuation fund may quote a figure for total return for the past year, which would be a combination of the growth and yield from the portfolio of investment assets held by the particular fund.  If you were looking at a parcel of shares in an individual company, or a number of companies, the information about recent growth in share price and dividend payments is readily available ( for companies listed on a stock exchange ).

However, when we are planning a wealth building strategy for the rest of our life, and are assessing a potential investment as part of that strategy, we need to be thinking about how the investment will perform in the future, as well as how it is performing currently or in the recent past.  In the case of a bank term deposit, the return quoted is actually the future return, and, barring any default on the part of the bank, you can be fairly certain of receiving the quoted return for the period of the term deposit.

But what happens when this term deposit expires?  What interest rate will the bank be offering in one, two or three years’ time?  We need to be able to make some reasonable judgement about what we expect will happen in the future.  When assessing a managed fund or other licensed investment product, you will always be advised to “consult the PDS”, and the PDS ( Product Disclosure Statement ) will always contain a line something like “past performance is no indicator or guarantee of future results”.  So if we can’t rely on past performance as a guide, what have we got to use as a basis for our judgements about future returns?

The reality is that people only ever predict the future by drawing on their experiences, i.e. looking at the past.

Our expectation that the sun will rise tomorrow is based on our experience that it has risen every day since we were born.  Our weather forecasts are based on entering thousands of observation into a complex computer model, but that model is still based on observation of actual weather patterns over many decades.  Our entry in the footy tipping competition is based on our observation of teams’ and players’ past performance.

But what about future interest rates?  Future movements in Bond yields and prices? Future share prices or future property prices and yields? 

There are many factors at work, and many of them are unmeasured or unknown, making any attempt at prediction a risky business.  But it is something that must be done if we are going to be able to put together a wealth building strategy with an expectation of providing a wealth base and a passive income for our future.

One important observation is that the consistency of past performance improves the accuracy of our predictions.  The movement of the earth around the sun is so consistent that we are able to predict the times of sunrise and sunset to the minute well into the future.  Our modelling of weather patterns has reached the point where we are prepared to give some credibility to a seven day forecast, whereas it is only a few years since three days was as far ahead as we were willing to look ( and I’m old enough to remember when the forecast was limited to the following day, and even then it was usually wrong ).

In an earlier article in this series, we talked about variability of returns from an investment, and that, given a certain level of return, most people will prefer an investment with lower variability, or more consistent returns.  Not only does more consistent past performance give a better chance of understanding potential future performance, it also allows earlier detection if performance has changed or is changing over time.

When building models to simulate projected future wealth, there are many variables that need to be accounted for, and our recommended approach is to make conservative assumptions about future values based on the best information available about long term past performance.  When incorporating an individual investment into a proposed wealth building strategy, we recommend taking a conservative view of future returns, and, the more variable past returns have been, the more conservative we need to be about setting an expectation for future returns.

Empower Wealth’s Personal Wealth Management Program includes a sophisticated Wealth Projection Simulator which allows you to see the effect of expectations of future return by modelling the effect of these different returns, together with many other factors which influence the long term financial outcome of an investment, to give you the numbers you need to make an informed decision about your financial future.

If you would be interested in seeing how these tools and techniques could be applied to your own personal financial situation, please come and see us for a free one hour consultation.