Why Aussie investors should think ahead
It is futile for investors to predict Australian share market returns within six or 12 months - instead, they should look well beyond the one-year horizon to properly assess how shares are likely to perform.
After the initial COVID-19 lockdowns in March 2020, no-one could have predicted the share market would rise by 37% over the next 12 months. This illustrates the inherent risk of a short-term focus towards investing, particularly in shares.
Any investment in the share market should last for a minimum of three years, however history will tell us the real benefits of an investment don't often materialise until well after five years of being in the market.
Ideally, the smoothing of share market volatility over time and the narrowing of likely outcomes with each passing year means investors should focus on 10-year forecasting, as this provides a more accurate reflection of market cycles and also allows for likely volatility.
However, the share market shouldn't be viewed as a 'set and forget' investment approach. Asset allocation should be reviewed every couple of years to ensure they are maximising the market value as prices can fluctuate considerably during this time.
When contemplating 10-year forecast returns, investors can make gradual changes to their asset allocation; the share market will not become a sell overnight! This will mitigate any emotionally-charged decision-making that can typically occur after a crisis.
For Australian shares, international shares, property or fixed interest investments, expected returns will ideally be forecast on a five year-plus horizon. Using this timeframe, the expected return for Australian shares over the next five years and beyond is around 8% per annum.
A large portion of this return - around 5.5% - is the dividend yield plus franking credits, while the remaining 2.5% will come from growth in share prices.
This is an attractive return compared to investing in term deposits, for example. Even though the Reserve Bank of Australia's cash rate has gone up from a mere 1% at the beginning of 2022 to now be over 4%, it's likely we are near the end of this period of continuous interest rate hikes.
In fact, we even think interest rates could even start to drop in the next few years and expect a term deposit investor will have an average return of 3.5% over the next five years.
While the expected return of Australian shares remains 4-5% above the risk-free term deposit rate, investors should continue to favour taking on some risk in their portfolios and building up Australian shares.
It is not until the Australian share market rises a further 30% before the outlook for Australian shares starts to look similar to term deposits. At this point, if it was to occur in the next couple of years, investors should consider reducing their exposure to Australian shares as the market is moving into overvalued territory.
These changes to the portfolio can occur gradually in 10% increments as overvalued markets will often stay overvalued and continue to rise for several years. Quite often, large movements in asset allocation, such as selling all your Australian shares and moving to cash, will have a big impact on the portfolio's performance.
The lesson here for investors is they must accept it is almost impossible to pick the tops and bottoms of markets. However, realising when the share market is in cheap or overvalued territory will greatly assist with good decision-making when it comes to asset allocation.
But most importantly, investors shouldn't be thinking, 'What's going to happen over the next six to 12 months?', but rather, 'How long do I wish to invest for, and what do I want to achieve?'.
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