Where we're going, we don't need roads...But we do need some carefully thought out guesses.

the future is built on (educated) guesswork

When it comes to investing for the future, there should always be a purpose around which a financial plan can be built. The amount we contribute to our plan is under our control. So too, is how we react to external stimuli such as the media or the stock markets falling (although behavioural scientists may argue otherwise!). Everything else has to be an educated guess; mortality, expected expenditure, investment returns etc. While Doc Brown famously pointed out in Back to The Future that roads wouldn't be required in 2015 (maybe he meant 2020!), there are always going to be some incorrect and some correct thoughts about the future. The most common term to use is "assumptions" but the further I explored, the more I realised that I was really talking about guesses. Well researched, backed by science and realistic, but guesses nonetheless.

Speaking of Behavioural science, we (humans) are known to regularly exhibit biases. We can't help it - apparently they date back to our cave dwelling days as a way to protect us (if you want to read or listen to more about this, let us know as we've got lots of resources). This blog post probably covers many of the 175 known biases but our focus is on "recency bias"; where we remember something which has happened recently compared to something that has happened a while back.

how does a fall in the market impact our assumptions?

The corona-driven market fall got us thinking about the educated guesses (assumptions) that have to be made. When a plan is built, we usually assume a linear growth rate for the purposes of discussing the options available; 4.5% (or 4% in a taxable environment) which has been set against assumed inflation of 2.5%.

We are not the only ones that have to make an assumption. The regulator mandates illustrations for growth of a portfolio at a "low", "middle" and "high" rate of 2%, 5% and 8% respectively, or lower where the platform or pension provider think the underlying assets merit lower rates. From this, deductions are made to demonstrate the effect of Inflation and charges.

By its nature, investing is a long-term concept, usually a minimum of 5 years but more often 10 years and ideally, forever. Anything shorter should be considered saving or speculating. So, if investing is meant to be for such a long term, why do we find ourselves focusing so much on stock markets falling by 25% in the last few months? Well, the media have a part to play as does our access to information thanks to the internet. But it is also very difficult for us mere mortals to put perspective on what is happening "now" compared to what has happened over a longer term.

I was discussing this with Chloe in our office and our professional curiosity got the better of us. We decided to look at what impact the recent fall has had on long-term planning. We did this by comparing the "linear" growth rates that we assume and those that the regulator require to the actual returns of a sample portfolio up to the recent lows. We also included inflation as measured by RPI over the period. The table below uses a sample portfolio with 60% in Global equities and 40% In Global Bonds - what is traditionally known as a "balanced" portfolio. The time periods are up until March 31st which was around the lowest point of the recent market fall.

So, what can we take away from this? Firstly, your financial planners enjoy wading through this data far too much! But, more importantly, the guesses (assumptions) that are essential for helping to plan for the long term need to factor in the bad times as well as the good times for stock markets. While a 60/40 portfolio has returned about 6.5% pa over the last 30 years, we assume a more conservative 4.5% to allow for particularly volatile periods. Over the last 12 months, the benchmark portfolio has returned far less than the "guessed" 4.5% and less than inflation. However, even at its lowest at the end of March, the 5 and 10 year returns from investing in a globally diversified portfolio were higher than the guesses and inflation.

From a professional perspective, our experience during these volatile markets help us to be better planners - it is our version of a training bootcamp. When it comes to our "guesses" to help people with their planning, it reminds us of the American Golf Pro Jerry Barber's quote, often attributed to fellow Pro Gary Player "The harder you practice, the luckier you get".

Your plan will never be exactly how things turn out - life doesn't work like that. And until Doc Brown and Marty Mcfly turn up with their Delorean, we'll have to make do with careful, sometimes a little conservative, guesses.

Jimmie Joseph and Chloe Thompson

Faith LiversedgeMay 25, 2020