Expected Returns vs. Hoped for Returns

Expected returns stem from the idea that investors need to be paid a return for taking on the risk of owning securities. No investor would own securities without having the expectation of returns, and as the securities being owned get riskier, the investor will expect increasingly higher returns. If there were no reason to expect higher returns for holding riskier investments, investors would only hold less risky investments. Stocks are risky investments, and investors have been compensated well for owning them. Bonds are less risky investments, and investors have not been compensated as well for owning bonds as they have been for owning stocks. Expected returns are based on the risk of the overall market (systematic risk), assuming that the risk associated with any individual security (non-systematic risk) has been eliminated through diversification. This is an important distinction; the securities of any individual company are exposed to random error (CEO gets sick, hurricane knocks out the manufacturing plant, etc.) and do not have an expected return. The stock can either go up, or it can go down, and the average of its expected outcomes is zero.

Investors who minimize their costs and capture the returns of the global markets with a well diversified low-cost portfolio are able to expect returns. Capital markets research has even shown that specific parts of the market have higher expected returns than others. This is discussed in detail in Larry Swedroe’s new book, The Incredible Shrinking Alpha, (request a copy here) but a simple example is: stocks have higher expected returns than bonds, value stocks have higher expected returns than growth stocks, and small stocks have higher expected returns than large stocks. Based on this, a properly diversified investor can structure a low-cost portfolio in such a way that they can expect to earn higher returns than a market index, like the S&P 500. Interestingly, most people don’t invest like this, but they do try to beat the S&P 500.

The majority of mutual fund assets invested in Canada are invested in actively managed mutual funds. An actively managed mutual fund is led by a fund manager who is responsible for predicting which stocks and bonds are going to perform well, with the goal of beating their relevant benchmark index (S&P 500 for a US equity fund, S&P/TSX Composite for a Canadian equity fund etc.). Unlike the well-diversified investor holding a market portfolio, who can expect to earn a long-term return for taking on the risk of the market, investors in actively managed mutual funds can only hope that their fund manager will pick the right securities to give them a return. Even if a fund has performed well in the past, there is no expectation that it will continue to perform well in the future, and most actively managed mutual funds in Canada underperform their benchmark over the long term. Many investors are realizing that it is better to expect returns than to hope for them, but a staggering 98.5% of mutual fund assets in Canada are still invested in actively managed mutual funds*.

*Investor Economics data as of June 19, 2015.

Original post at pwlcapital.com