Do Expected Returns = Actual Returns?

Disclaimer: Please note that all content and information in this blog are for educational and informational purposes only and should not be taken as professional investment advice.

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In finance, many try to predict future asset prices based on expected returns. While this approach is conventional, there is an inherent fallacy with it. Firstly, expected returns are based on historical returns. Almost every concept in finance in built on historical data. Yet, almost everyone in the world of finance and investing knows that historical performance ≠ future performance.

But why then do people still use historical performance to predict the future?

Simply because there's no other alternative. If we don't use historical data, we won't have anything to base our future predictions on. Yet, using historical data to predict the future is risky because we can never predict with reasonable certainty the expected return of an asset like equities. 

The inherent volatility and unpredictability of equities makes predicting them an almost impossible task. While we might be able to predict them correctly once in a while, the ability to consistently predict future performance with reasonable accuracy is an impossibility.

So, instead of trying to predict the future, why not accept that the future is unpredictable? 

As investors, instead of trying to predict the unpredictable, what truly matters is how we position ourselves to win where we can. In other words, using what we know and what we have to achieve returns. It doesn't matter what we don't know but what we do know and do have. Rather than trying to predict what our returns would be, we can simply focus on optimising our returns using what we have. 

Instead of falling prey to the fallacy of trying to estimate, quantify or predict our future returns, the best thing we can do as investors is to remain mentally prepared for the unpredictable — to prepare for the worst but hope for the best. In this way, when the unpredictable happens, we will not be caught off guard. Instead, we would be prepared both mentally, emotionally and financially for the unexpected and unpredictable headwinds coming our way. 

By aiming to be prepared for the worst, we will be able to survive market calamities and consistently produce above average returns in the long term. Achieving above average returns is what matters. As long as we win more times than we lose, we would be better positioned to achieve strong and sustainable returns over the long run. 

We don't need to know what our returns are going to be. We just need to know we're going to perform better than the average — that is, the market.

Adopting this mindsets and attitude to investing will enable us to adapt more easily to unpredictable market changes and withstand the uncertainty and volatility of the market. Instead of spending time trying to predict our returns, this time would be better spent at sharpening our mental and emotional fortitude and resilience that are critical during market crashes or prolonged periods of market pessimism and financial turmoil.

If we can withstand the bad days, we'll remain to see the good days. And the good news is that the good days always outnumber the bad days.

Secondly, expected returns are simply an average—they don't tell us exactly where an asset is headed to, but simply tell us that on average, it leads to X% returns, but the probability of X happening is as improbable as any other value. 

Why? Because probability distributions are a cumulative distribution. 

There is an infinite number of possibilities with a cumulative distribution. So in theory, the probability of getting X % of returns is zero since there are an infinite number of possibilities on what the expected return can be. Thus, using expected returns to evaluate actual return is an inherently impossible task. Hence the chance of us getting the actual return spot on with our expected return is practically zero. If it does happen, it is likely due to pure chance, and not an indication of our ability to predict returns.

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Disclaimer:

The content and information provided on this blog is solely for educational and informational purposes, and should not be construed as financial advice. The accuracy or completeness of the content and information provided in the blog cannot be guaranteed. Before making any investment decisions, it is important for readers to research and carry out independent verification of the information provided, or consult with a qualified financial professional. No warranty and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of actions taken based on the ideas or information found in this blog.

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