Swedroe: Expected Returns & Black Swans

October 29, 2014

Having the right plan and sticking to it means understanding how returns really work.

One of the more common mistakes many investors and even some financial advisors make when developing an investment plan is in treating the expected return of a portfolio as “deterministic.” They tend to think about expected returns in terms of a specific figure that a portfolio is anticipated to earn.

Expected returns, however, are simply the mathematical mean of a potentially very wide dispersion of prospective outcomes. The mistake occurs in supposing they are exact projections.

That error can prove very costly because it may lead investors to assume more risk than they have the ability, willingness or need to take. As the late Peter Bernstein once explained, “The greatest risks we take are when we are certain of the outcome.”

The graph below demonstrates the correct way to think about the expected return of a portfolio, an asset class or an individual stock.

Stock_Returns_&_Black_Swans

Understanding Distribution Of Possible Returns

Although expected returns are not actually normally distributed, I believe this illustration is helpful in explaining a framework for how to consider them. Think of Portfolio A as marketlike, such as a total stock market fund. The illustration shows that the expected return is 7 percent. But it also shows that the 7 percent return is just the mean (and in this case, the median) of a wide dispersion of possible outcomes.

In other words, there is a 50 percent chance the return will be above the expected 7 percent, perhaps a 30 percent chance it will be above 9 percent, a 10 percent chance it will be above 12 percent and a 5 percent chance it will be above 13 percent. There is a similar potential that returns will fall on the left side of the distribution.

 

 

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