Investing Amid Low Expected Returns

Making the Most When Markets Offer the Least

Antti Ilmanen

• Verlag: Wiley
• Jahr: 2022
• ISBN:
  9781119860204
• Auflage: 1
• Thema: Personal Development
• Thema: Personal Finance

Elevate your game in the face of challenging market conditions with this eye-opening guide to portfolio management

Investing Amid Low Expected Returns: Making the Most When Markets Offer the Least provides an evidence-based blueprint for successful investing when decades of market tailwinds are turning into headwinds.

For a generation, falling yields and soaring asset prices have boosted realized returns. However, this past windfall leaves retirement savers and investors now facing the prospect of record-low future expected returns. Emphasizing this pressing challenge, the book highlights the role that timeless investment practices – discipline, humility, and patience – will play in enabling investment success. It then assesses current investor practices and the body of empirical evidence to illuminate the building blocks for improving long-run returns in today's environment and beyond. It concludes by reviewing how to put them together through effective portfolio construction, risk management, and cost control practices.

In this book, readers will also find:

• The common investor responses so far to the low expected return challenge
• Extensive empirical evidence on the critical ingredients of an effective portfolio: major asset class premia, illiquidity premia, style premia, and alpha
• Discussions of the pros and cons of illiquid investments, factor investing, ESG investing, risk mitigation strategies, and market timing
• Coverage of the whole top-down investment process – throughout the book endorsing humility in tactical forecasting and boldness in diversification

Ideal for institutional and active individual investors, Investing Amid Low Expected Returns is a timeless resource that enables investing with serenity even in harsher financial conditions.

Part I
Setting the Stage

Chapter 1
Introduction

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• Lower asset yields and richer asset prices have brought forward future returns. The payback time for the recent decades' windfall gains is approaching.
• Most assets are expensive compared to their history. It is not just bonds.
• Few investors have had the serenity to accept low prospective returns. Most hard choices have been delayed. Reaching for yield helps only so far.
• Good investing practices such as discipline, humility, and patience are timeless but become even more important in tough times. Focus on what you can control.
• This book's first part sets the stage. It puts the low expected return challenge and different investors' responses in broad historical context.
• The second part reviews the building blocks that may help improve long-run returns. It updates and extends evidence on market risk premia, illiquidity premia, style premia, and alpha.
• Those blocks still need to be put together. The third part covers portfolio construction, risk management, ESG, cost control, tactical timing, and bad habits.

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1.1. Serenity Prayer and Low Expected Returns

Serenity Prayer versus St. Augustine's Prayer

The Serenity Prayer can give fresh insights when investors are beginning to face the challenge of persistent low returns, having been spoiled for a generation.

God, grant me the serenity to accept the things I cannot change,

the courage to change the things I can,

and the wisdom to know the difference.¹

It is no news that historically low bond yields and high asset valuations point to a low expected return world. Meanwhile, many investors have gotten used to strong realized returns as rich assets have grown ever richer. Several market observers, myself included, have asked investors to acknowledge this disconnect and to adjust spending plans and investment plans accordingly.

Few investors have shown the “serenity to accept” the lower expected returns in the sense of moderating their future spending plans. Many more have shown “the courage to change” in moving into riskier investments when the market no longer offers the expected returns these investors have grown used to. Collectively, we are due for a disappointment as we cannot all buck the fate of lower expected returns. So it seems “the wisdom to know the difference” has been lacking.

A subset of retirement savers understand that they must save more now that the market offers less, and a few institutions are belatedly lowering their return expectations and planning belt-tightening. Most, however, keep delaying hard choices and follow the youthful St Augustine in praying: Lord, make me chaste – but not yet.

This take-risks-and-kick-the-can approach has worked quite well during the past decade – not least thanks to the generous central bankers, for whom even agnostic investors should praise in their evening prayers. The period since the Global Financial Crisis (GFC) has been a time of low growth, low inflation, low interest rates – low everything except realized investment returns, it seems. Some say this is because we borrowed returns from the future: not through standard borrowing (although plenty of that took place too) but rather through the windfall gains from ever-lower yields and ever-richer asset valuations. These boosted the post-GFC realized returns but promise even harder times for the rest of the 2020s and/or beyond.

Finally, many investors have adjusted neither their return expectations, nor investment plans, nor spending plans. Wishful thinking can be explained by “rearview-mirror” expectations: Since past returns have been healthy, why should we expect anything different from the future?

Extrapolating the strong market performance since the GFC as an indication of the future would be a wrong lesson to draw. We learn slowly from data, and even a decade is a short period to learn about long-run expected returns, especially if realized returns have been driven by large valuation changes.

While we should be humble about predicting returns, I believe that the next ten years will be characterized by low realized returns, not just by low expected returns. I hasten to add that when record-low cash rates are at the heart of the problem, going to cash is not the obvious answer. Any putative market timer will have to be very lucky to get the timing right.

So investors need to take risk to earn any rewards. It is especially important to do this efficiently and intelligently now that the rewards are likely to be meager. And investors should take risks with wide-open eyes when the risk of disappointment – fast or slow – is higher (more on the “how” soon).

Serenity Prayer Versus Outcome Bias

Investing with serenity is not only about calmly accepting low returns. It is about investing thoughtfully, understanding one's investment goals, and figuring out best ways to reach them. We need to make the most when markets offer the least. While on this journey, investors should focus more on the process than outcomes. This is another important connection between the Serenity Prayer and investor behavior. Outcome bias refers to the all-too-common tendency to equate the quality of a decision with the quality of its outcome.² Few investors serenely accept an extended period of disappointing performance. Yet, overreacting to past performance is not a recipe for long-run success.

When it comes to realized returns, luck dominates skill over months and even years. Good investments will have bad periods. In relatively efficient markets, competition means outperformance cannot be as reliable as we'd like. We can see consistently successful surgeons or engineers but observe that investors do not achieve comparable consistency – if we measure success by short-term outperformance.³ Good investors are anchored by market outcomes and relatively close to 50/50 short-term odds around them. Odds of outperformance tend to increase with a longer horizon, but more slowly than many investors accept. A long-run positively rewarded strategy or a skillful investor can have painfully long bad patches. Equity markets do experience losing decades (most recently in 2000–2009) and even Buffett has suffered underperformance longer than a decade.

Statisticians say we may need decades to distinguish luck from skill in investing. Yet, most investors shrug and judge investments based on the past few years' performance – at most. Sadly, it is not enough. In reality, most of us cannot give investments as much patience as is rationally needed. Impatience leads to ill-timed capitulations at asset class level and wasteful fire/hire decisions in manager choices.

There are no easy solutions to this perennial challenge, but we can all try to do better. Investing with serenity is about investors and managers accepting what cannot be changed – that the outcomes over short and even quite long horizons are dominated by luck or randomness. Instead, judgments should focus on what can be controlled: improving expected returns by improving the investment process and decision-making quality.

I understand that this may sound preachy, especially given that some of the systematic style str...