You may have read that well-known stock indices in the US and Europe have reached new highs in recent months. Is a new market high an indication that it is time for investors to cash out?
History tells us that a market index being at an all-time high generally does not provide actionable information for investors. For evidence, we can look at the performance of the MSCI World Index for the better part of the last half-century.
From 1970 to 2016 (see Exhibit 1), the proportion of annual returns that have been positive after a new monthly high is similar to the proportion that have been positive after any index level.
In fact, almost a third of the monthly observations were new closing highs. Looking at this data, it is clear that new index highs were not useful predictors of future returns.
So, if the level of an index by itself does not have a bearing on future returns, what does?
One way to compute the current value of an investment is to estimate its future cash flows and calculate their value today. This type of valuation method allows expectations about a firm’s future profits to be linked to its current stock price through a “discount rate”. This rate is equal to an investor’s expected return. This valuation method tells us that the expected return from holding a stock is driven by a combination of the price paid for it and what its investors expect to receive.
Stock prices are the result of the interactions of many willing buyers and sellers. If investors apply positive discount rates to the cash flows they expect to receive from owning a stock, they should expect the price of that stock to represent a level such that its expected return is positive. It is extremely unlikely that, in aggregate, willing buyers of stock apply negative discount rates to the expected profits of the firms they are purchasing. If they did, it would imply they collectively expect a negative return on investment. If this were the case, why would they buy at all?
Therefore, it is reasonable to assume that the price of a stock, or the price of a basket of stocks like the MSCI World Index, should be set to a level at which its expected return is positive, regardless of whether or not that price level is at a new high.
It is important to make the distinction between expected and realised returns. The latter may be negative or positive because of changes in expectations. If either expected returns or expectations about future profits change, prices will also change to reflect this new information. Changes in risk aversion, tastes and preferences, expectations about future profits, or the quantity of risk can all drive changes in expected returns.
This all helps explain why new index highs have not, on average, been followed by negative returns. At a new high, a new low or something in between, expected returns are positive.
Choosing the correct Ethical or Socially Responsible investments will depend on your own beliefs and values. A starting point is to use a screening process.This will help you to analyse which types of industries and companies they would like to either include or exclude.
There are primarily two types of screening, positive and negative.
The process of Negative Screening excludes investments that you might consider undesirable. For example you might want to exclude some of the following:
Positive screening helps to identify the businesses that demonstrate the potential to offer good quality, long-term ethical investment opportunities. The positive screening process will help you to avoid businesses that could encounter problems as their day to day operations might not be sustainable in the long term. Positive Screening might include companies involved with
By employing active shareholder engagement it is possible for shareholders and fund managers to encourage a more corporate and social business approach.
It makes sense to consider investing into companies that have the foresight and willingness to adapt.
Anyone seeking evidence that investment decisions can be hard often needs to look no further than the front page news. China, oil, VW and Glencore are among the assets that have made the headlines in the past few months after suffering sudden, unexpected and dramatic changes in price.
Investors with exposure to those volatile assets might be licking their wounds and reconsidering their positions. This is because many investors have an investment strategy that relies on their (or someone else’s) forecasts about the future. In the simplest terms, their starting point is a blank sheet of paper, where they build a portfolio of assets they think will do better than the alternatives. Sometimes those decisions are right; sometimes they are wrong.
We have a different starting point. Our investment philosophy is based on things we know rather than things we don’t know. For example, we know that financial markets do a good job of setting prices, so we don’t try to second-guess them. Instead, we begin with the belief that investors will, on average and over time, receive a fair return for investing their money.
Our aim is to give our clients access to that long-term return through broadly diversified, low-cost portfolios of assets that aim to beat the market average. The portfolios do this by using information in market prices that tells us about a security’s characteristics and its expected future returns.
The decisions we make about what assets to hold are based on decades of academic research rather than short-term hunches. This means we can focus on meeting your long-term goals rather than becoming absorbed by short-term market movements.
Generally speaking, investment decisions are hard, but if, like us, you start with information you know is backed by decades of evidence and build an investment philosophy and strategy around it, we think you can improve your chances of being a successful investor.