After a strong recovery in markets since the Covid-19 setback, we have lately been finding a lot of people anchoring their financial objectives around doubling their money.
We are entering 2022 with stocks at or near all-time highs. US large-cap growth stocks, for example, are up more than 100% from the market bottom – from 31 March 2020 to 30 November 2021 – according to Factset data. This has been kickstarted by an unprecedented amount of fiscal and monetary stimulus and sustained by rising investor exuberance – as seen with IPOs, ‘special purpose acquisition companies’ and meme stocks.
The strong returns witnessed more recently have, however, led to extreme valuation expansion across several parts of the market and, as some individuals extrapolate recent returns into the future, we are finding many of them are taking on too much investment risk.
Focused approach
This environment demands an increasingly focused approach to portfolio construction and a grounding in base rates rather than weaving a story based on causal links or extrapolating recent events. The results of a statistical approach to examining what happened to an appropriate reference class of cases over history are called ‘base rates’. This is an area we can add value – not to promise quick riches, of course, but to highlight the ‘Rule of 72’.
This rule tells us how long it will take to double our money in the markets. It supports the old adage that investments in growth assets, such as shares or property, tend to double approximately every 7 to 10 years, while investments in defensive assets, such as bonds, might take some 15 to 35 years to double in value.
In essence, the Rule of 72 tells us how long it will take us to double our money at different rates of return. It is a simple mathematic equation: Number of Years = 72 / Expected Return. If we expect to generate a 1% return each year, the rule suggests it will take us 72 years to double our money; if we expect to generate a 10% return each year, it will take 7.2 years. Looking at it in a different way, if we need to double our money in 10 years, we need to achieve a 7.2% return each year.
Long-term base rates
These rates of return may seem low relative to recent experience but this is precisely why it is so important to be mindful of long-term historical base rates. From 1970, global equities returned 9.4% annually in local currency terms, according to Factset; meanwhile, according to Morningstar Direct, cash (GBP) returned 5.2%. That being so, the recent 100% growth in US large-cap growth equities from market bottom is far from historical expectations.
Of course, the Rule of 72 is simply a rule of thumb, as markets do not move in straight lines and forecasting future returns is incredibly difficult. That said, we know through research and experience there is a trade-off between risk and return. Taking more risk can lead to more return, but we should never take more risk than we are comfortable with.
Used correctly, the Rule of 72 can be an important factor that we must weigh up when we invest. It is especially important for helping set base expectations on reality for individuals who want ultra-fast returns but have not had enough investment experience or who are missing the important long-term historical perspective.
This rule is great, mostly because of the simplicity. It showcases the power of creating good money habits – putting money aside to generate returns that compound each year, turning financial dreams into financial goals. This is a more prudent way of accumulating wealth than chasing ultra-high and fast returns through extreme risk-taking.
Future cashflows
In this environment – where an individual’s judgement may be influenced by more recent turns of events – it is important to think long-term and also remain mindful of the fundamental difference between investing and speculating. Investing ultimately boils down to finding good-value opportunities in the market. In other words, we look to identify assets in which the value of the future cashflows is greater than the price paid to acquire them.
A fundamentally attractive asset can become an unattractive investment when purchased at a high price and, by the same token, a fundamentally weak asset can provide the most attractive returns when bought at a sufficiently low price. The importance of this dual focus when undertaking investment analysis tends to be lost in markets characterised by excessive optimism or pessimism.
As investors become increasingly focused on the future path of prices, confident of either a continuation of the past or a sharp reversal, many forget that most paths lie between these two outcomes. The right approach to long-term investing is to view the future probabilistically and to keep base rates in mind.
Leslie Alba is associate director of research at Morningstar Investment Management Europe
