How do professionals forecast long-term market returns?

In this episode, Mark and Shani speak with Bianca Rose, Senior Portfolio Manager at Morningstar Investment Management, about how capital market assumptions are built and why they matter for investors planning their financial goals.

From equity valuations to fair value, risk premiums, interest rates and behavioural overreactions, Bianca explains how Morningstar’s team analyses over 300 asset classes to forecast 10-year and 20-year return expectations.

You can find the transcript for the episode below:

Shani Jayamanne: Mark and I have had very different lives. Mark had his first investment before the age of 10. I started investing after I started full-time work. Our lives, financial goals and experiences have meant that we have very different investment strategies.

Mark LaMonica: We do have a few things in common, though. The first is that we’ve spoken to hundreds of investors about their journeys and understand what is most helpful for them.

Jayamanne: The second is that we both work at Morningstar because we’re able to do this with independence. We don’t have to recommend a particular product or asset class. Our only vested interest is in helping you achieve your outcomes.

LaMonica: The last is that although we have vastly different life experiences and differing investment strategies, the fundamentals and the underlying principles that we follow are the same. And it’s these principles that we take a deep dive into in our book, Invest Your Way.

Jayamanne: Invest Your Way is a guide to successful investing with actionable insights and practical applications. It focuses on the investor instead of the investments. You’re able to purchase the book and audio book through the links in the episode notes, through major bookstores or request a copy through your local library.

Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

LaMonica: We had a meeting yesterday, Shani, with our publisher.

Jayamanne: We did.

LaMonica: Which sounds a little ridiculous to say. There are some logistical issues. I went to the wrong coffee shop. She went to the wrong coffee shop. But a different one.

Jayamanne: Yes.

LaMonica: But anyway, we did have this meeting. Because the book is out – the book came out last week.

Jayamanne: Woo-hoo.

LaMonica: I know it’s exciting. We signed 500 copies.

Jayamanne: It was mammoth.

LaMonica: Which was exhausting. And we were in between – so we went to Booktopia.

Jayamanne: Yes.

LaMonica: And we were in between – the guy before us was the guy that writes the wimpy…

Jayamanne: Diary of a Wimpy…

LaMonica: Who sold like a billion copies.

Jayamanne: Yes.

LaMonica: And then the next day Tony Abbott was coming in.

Jayamanne: Yes. Mr. Abbott.

LaMonica: Mr. Abbott.

Jayamanne: Yes.

LaMonica: That’s how they were told to refer to him.

Jayamanne: Yes.

LaMonica: So anyway, the book is out. We obviously would appreciate it. If anyone’s interested in buying it, it’s in 202 bookstores across Australia, which we were surprised at. They sent us a list of some strange places.

Jayamanne: Yes.

LaMonica: Like regional airports in WA.

Jayamanne: Yes.

LaMonica: But anyway, obviously we would love anybody’s support that wants to buy it. We saw the inventory list. There’s a lot to sell.

Jayamanne: Yes.

LaMonica: So, let’s get into today’s episode. And we have a guest episode. And our guest is from Morningstar’s Investment Management Division named Morningstar Investment Management.

Jayamanne: Appropriately named.

LaMonica: Not very creative, but honestly a lot of these fund managers with new names, the names are…

Jayamanne: I’d be too creative.

LaMonica: A little too creative. So, who’s our guest?

Jayamanne: So, it’s Bianca Rose. And Bianca is a senior portfolio manager who has been with Morningstar for 19 years. She’s extremely experienced in managing portfolios, but is also fantastic at explaining how things work in a way that makes sense for everybody.

LaMonica: And what we want to talk to, and what we will talk to Bianca about today is capital market assumptions. So, what is that, Shani?

Jayamanne: So capital market assumptions is a fancy way of saying the expected returns that Morningstar Investment Management has for different asset classes. So, they’re forecasts.

LaMonica: And forecasts, of course, are important. We talk a lot about goal setting on this podcast and to properly define a financial goal, there are a couple of variables that are needed. So, you need to know how much money, of course, you have now. You need to know how much you want. So, what’s that goal amount? You need to know the amount of time in between now and when you want to accomplish your goal. And you have to know how much you are going to save. And of course, you have to account for inflation.

Jayamanne: And we’re going to talk to Bianca about the last factor or variable, and that is required rate of return for your portfolio. And this feeds into your asset allocation for your portfolio and the amount of each asset that you need to hold.

LaMonica: And every asset class has different risk and return profiles. So, the higher your required rate of return, the more aggressive you want to be. So, the more aggressive assets you want to hold. The lower your required rate of return, the more conservative assets you’re able to take on and put in your portfolio. And you need to set this asset allocation so that you have a reasonable chance of achieving the return you need to get to your goal.

Jayamanne: And what a lot of people base this mix on is normally historical returns. For example, if equity markets achieved 10% over the last 20 years, they’ll use that as a basis to understand how much they need to hold in their portfolio.

LaMonica: And nobody has a crystal ball, but projected future returns is just a little more of a holistic view on what might actually happen. And we’ll talk to Bianca about this and she can talk about how Morningstar Investment Management thinks about this and how they come up with these assumptions. But these projections allow investors to base their asset allocation on more than what’s just happened in the past because that might not, of course, represent what’s going to happen in the future.

Jayamanne: And these projections aren’t meant to be taken as gospel, but they provide reasonable guidance for you to set your asset allocation in your portfolio.

LaMonica: Okay. Well, let’s get into the interview with Bianca.

Well, Bianca, thank you very much for joining us. Shani and I walked through and went through your title. And I think a lot of listeners can’t exactly figure out what does a senior portfolio manager do. So maybe if you could talk a little bit about what you do here at Morningstar and kind of your day to day that keeps you busy all week.

Bianca Rose: Sure. So, first and foremost, yes, I am a portfolio manager. What does that mean? So primarily I take care of our multi-asset portfolios, so our real return multi-asset portfolios and also managed account portfolios. So that means that they invest in a variety of asset classes, mainly on the growth side and also on the defensive side.

So, what do I do all day? I decide, first and foremost, what’s the mix of the growth and defensive assets we’ll have. And then within those, what’s the types of strategies and the asset classes we’re going to own within those. And there’s a whole range that we can own. In addition to that, I also do take care of some of our sector-specific portfolios. So, like our infrastructure and some of our multi-manager Aussie equities and global equities portfolios. So that keeps me busy as well as looking from, I guess, a sector-specific angle as well as that multi-asset sort of top-down angle.

LaMonica: And I assume you’re doing a lot of research on your own. I know you have a team getting inputs from analysts. Is that – that’s kind of the day to day?

Rose: Yes. So, the day to day is looking at research of where do we want to be positioned in different positions, which positions are actually paying off for us? Where do we want to say maybe start harvesting those positioning? And what I mean by that is if they’re doing really well, we might start trimming some of those positions. And then we’re always looking for new ideas to populate our portfolio. And then there’s some positions that we’re just going to own for the long term and just let those compound. So, it’s kind of a variety of things of watching markets, being aware of market movements and being ready to take advantage of price fluctuations that arise alongside doing our day-to-day research.

LaMonica: Okay, great. Now, one of the inputs I know into basically everything you were talking about is what are called capital market assumptions. And I think that might be a term that’s unfamiliar to people. So maybe if you could define it first and then talk about how you, how Morningstar Investment Management comes up with them.

Rose: Our capital market assumptions are really our forecasted returns. So, what we’re thinking, are they going to be the returns on a future basis rather than on a historical basis? And what we’re looking to do there is we look at two sets of capital market assumptions. One are what we call as our fair value assumptions. So, what we think over the long term is a fair return for that asset class. And we basically have two return components to that, one being yield. So, whether it’s a fixed income or an equity asset, you’ll earn a yield from that. So, in the case of equities, you might have a dividend yield. You also have this concept of share buybacks where a company may buy back some of its stock if it thinks it’s a good capital allocation decision. And that comes back to shareholder as well. So that’s another way you can earn yield. And then on the fixed income side, I think it’s really, really simple. It’s usually just the headline yield on offer on that bond. Usually, if you hold that to maturity, you’ll get that yield.

Now, obviously what changes though is you don’t always hold something always for long term and so on. And so, there’s some other elements. Now, when we look at the equity side, the other part that kind of impacts the fair value is obviously cash flow growth or earnings growth. So that will change the yield that you get over in the future. So, you might not be earning a lot of yield today from an equity investment, but it could grow in terms of that cash flow profile. And so, you would expect to get more yield in the future. So those are kind of the two primary elements.

And then the third element is of course, valuation, which is where I think people spend a lot of time thinking about those price movements and what’s – is the stock cheap or is it expensive? And that’s probably the other part to our world alongside that long-term assumption is we’re trying to work out for that kind of particular asset class, is that cheap or richly priced today, and we’ll look to trade around that if you like.

LaMonica: And that is something that we do talk about on this podcast a lot to have investors think of the owner share. Where does the return come from? Well, you get a dividend, earnings grow and investors are willing to pay more or less or the same for those earnings. That’s interesting, but you’re doing this at an asset class level. So, you’re thinking about obviously you’re running these multi-asset portfolios, you’re saying we think Aussie shares will do this over the next – and you’re going long term with these, correct?

Rose: So, we’re pretty much going over a 10-year cycle for that valuation component and on the very long term for that fair value we’re looking around 20 years.

LaMonica: Okay.

Rose: So, it’s quite long term. But obviously, when we say that 10 years, that’s where we’re using a full market cycle, but in reality, we find some of those valuations don’t take 10 years. We call them vintages, if you like. So, we might have a vintage that we get into a position we have a thesis and that valuation opportunity plays out in a year. Or it might play out in three years and in some cases, it might take 10 years. So, what we’re trying to do is have different variety of those valuations. We’re using that 10 years as our full market cycle, but we expect that they’re going to be different, I guess, vintages to them of – like when you think of wine and it matures at different times, it’s the same thing with our positions.

And in terms of asset classes, I mean you talked about, say, something very broad like Aussie equities, but we also go quite granular. We might say, okay, we’re looking at Australian financials, if you like, or Australian resources and we might look at the Japanese yen as well. For instance, on a currency or bonds, we might say, okay, we’re going to look at US government bonds. We might look at US IT. We also look at US property. So, we look at a whole bunch of stuff and in the end, we’re having over 300 asset classes to choose from.

LaMonica: Wow. Okay. Well, that’s impressive. Now, I think people lose sight of this because Trump sends one tweet and the market falls and then another one and the market goes up. But things have obviously been pretty good for equity investors, share market investors around the world since pretty much the GFC. Obviously, there’s been a couple of dips, but I guess when you’re looking at your capital market assumptions, specifically, I guess for share markets, how do they look compared to history? You think they’re going to be higher, lower, stay the same? What are you guys thinking right now?

Rose: Yes. So, in general, we think they’re quite richly valued, but we do think – I think that’s when we definitely look at the US equity market, which is the biggest global equity market, we think that’s the case. When we maybe look at some other areas, we do see some pockets of value in emerging markets and some of the, I guess, developed markets outside of the US, also in, say, Japan and so on. For us, I guess the way we look at it is, a lot of people look at history and say, okay, that’s what we can expect for the future. We’re kind of looking at it maybe in an opposite sense and saying, if historical returns have been quite good, maybe that means the valuation has gone up. And so, it’s a little bit harder to get those returns in the future. And when we look at the US market, which has obviously been a very, very good performing market over the long term, that’s kind of where we’re coming from.

Now, obviously the unknown factors today and in the future is always there’s technological change and the level of competition and things like that. And so, obviously, things that are featuring more highly in US equity valuations today is related to tech and AI. And so, whether those things come to fruition may justify a high valuation, but for us, it’s always a higher bar and higher probability that you have – it’s harder to assume that that is baked in when you have that higher valuation, if you like.

LaMonica: Now, when you say valuation, so I think people think different things. So, there’s obviously like a relative valuation measure, like price to earnings, but is that what you’re looking for? Or you’re looking – you talked about fair value. And I think a lot of listeners are familiar with from our equity research team, their fair value. What are you looking at when you say…?

Rose: So, we actually look at it from both angles. We do input some of the outputs from our Morningstar Equity Research team, but we also look at it from that typical price to earnings valuation multiple. And what we’ll do is usually start with the idea of that earnings yield and income yield. So, if we kind of get back to basics, that’s why you buy an equity at the end of time. I think a lot of people get caught up in the capital prices and the things like that. But really, what that is all reflecting is, at the end of the day, you expect some sort of return from buying an asset because it’s an investment. And when we look at it, we look at those price to earnings multiples and we invert that to make an earnings yield by just taking the earnings over the price. And then we’ll say, what’s the payout ratio? And then that’s the expected yield that you’re going to get.

And so, for us, when we’re setting a fair price to earnings multiple, we’ll look at those sorts of things and then look at alongside also the earnings growth. So, what do we see as the earnings yield today, but also how do we expect that to grow in the future? And that will give us to, I guess, what is like a terminal fair price to earnings multiple. And then we’ll look at it today and say, do we think it’s more richly priced or more cheaply priced than that?

LaMonica: And what – I mean, I think people can probably figure this out, but you say you’ve got these 300 different slices of different asset classes that you’re looking at. How does this then go into that portfolio construction process where you’re creating these multi-asset portfolios?

Rose: We look at it from two angles. So, as you alluded to with relative valuations, we’re looking at returns relative to each other, but it’s not as simple as just picking the highest returns. We also then looking at versus its fair value because, for instance, an emerging market equity could look like a very high returning asset, but it’s got different elements to it. So, it may not be – although we do see it cheaply priced today, but it may not be priced fairly versus its fair value. So, we do look at it from different earnings growth profiles, different income yield profiles. So, every asset isn’t priced the same. And so, for us, it’s also an absolute valuation thing of is this cheap versus what you’re getting for that type of asset class? And we’re looking to have different drivers in the portfolio.

So, the other thing that when we think about portfolio is obviously everyone talks about the concept of diversification. Well, that’s very true for a multi-asset portfolio manager. We’re looking for elements that give you a bit of income yield, a bit of earnings growth. When we look at earnings growth, it’s not just simply the number, it’s the source of that earnings growth. So, we’re looking for a variety of things to happen because the earnings growth will come to fruition in different scenarios. So, we’re looking for different ways to win on that. And then we’ll look at the valuation. And obviously, all things equal, we’d like something that’s a little bit more cheaply priced than the more expensively priced. But again, it may be in certain instances where the earnings growth can outcycle a very expensive valuation depending on the timeframe you have. When people talk a lot of time about having a long-term investment timeframe, that’s because you can probably outcycle a high valuation through those earnings growth, which is what we’re seeing with the stock market over the long term.

LaMonica: Okay. So basically, what you’re saying there is that – I think a lot of people look at something like a price to earnings and they’re like, oh my God, the Magnificent 7 is so highly priced compared to whatever else they’re looking at, but they are also great companies. So, I guess you’re just talking about at a certain point, if you are growing fast enough, higher valuations are worth it, which I guess makes things hard, obviously, to do your job.

Rose: Exactly. Yes. And that’s the tricky part, right? It’s always trying to work out, is that fair? Because we don’t treat an IT stock the same as a consumer staple stock. A consumer staple stock has a very different growth profile to say an IT stock. And so, we always say it’s like when you go shopping, you wouldn’t pay the same price for a Kmart t-shirt as you might for, I don’t know, a Chanel or Prada, Hamburg or something. So, it’s always like that concept of what’s the quality or what’s the good that you’re buying versus the price you’re paying.

LaMonica: And that’s why I think it’s like – that’s why it’s called a relative valuation measure, right? Like it’s not telling you anything absolute. Like you have to make that judgment. You can compare things, but yes, you have to make that judgment.

Rose: Exactly. Yes.

LaMonica: And what do you think, I guess, lessons – most of the listeners are individual investors. I mean, they’re not going to do what you do. They’re not going to have 300 different slices of global markets and try to tinker. What are the sort of lessons you think individuals can take?

Rose: So, I think keeping simple. So, I think just understanding, first of all, is your primary goal when you’re investing, what kind of return profile do you expect? And do you want it to kind of – do you want income returns today or you’re looking for earnings growth in the future? Do you not need that income today, but you’re going to need it in the future? So, thinking about those sorts of things in terms of your magnitude of returns that you’re wanting, how do you want to get there? Do you want to get there via an income yield? Do you want to get there by a bit of earnings growth? When do you need that income? What’s your timeframe? If you’ve got quite a short timeframe, can you kind of – if markets are richly priced, can you wear it? Or if you have a very long timeframe, you could potentially wear volatility and you can dip in on underperformance and things like that. So those are the things I think people have to keep in mind is, A, what are the return goals? What are the sources that they want to get to those return goals? And then lastly, what’s the timeframe for investing?

LaMonica: And how often do these change? So, you obviously have these capital market assumptions. How are these changing daily when the market moves? How often do you look at them?

Rose: I think that the principles are not changing, like in terms of those return drivers, but what’s obviously changing every day as you alluded to earlier with tweets from different government politicians and different…

LaMonica: You won’t say his name, which is fine.

Rose: Or when you’re thinking about, oh, there’s some technological breakthrough that we’ve seen, whether it be Nvidia coming out on AI and then a couple of years later, we see DeepSeek coming out of China and that impacts markets. So, I think there is always new news that the market is factoring in. I think the thing that changes is obviously the price and the expectations. And so, that’s always changing, what is the multiple, valuation multiple, on the price earnings that people are willing to pay because they are changing their view on the earnings growth profile.

LaMonica: And how –you talked a little bit about news and events and there’s always worries. I mean, I think people lose sight of that. 10 years ago, people were worried about something else, but with tariffs and all sorts of things going on in the world, are there particular things that Morningstar Investment Management is worried about keeping their eye on? I mean, I assume everything, but…

Rose: There’s nothing particular. And we deliberately say that because we’re not trying to predict the latest geopolitical conflict. We’re aware of them and we’re aware of what’s being priced into markets, but we’re never trying to be positioning in one scenario. So, I think people might think of multi-asset investors as, oh, you have a view on where interest rates are going to go on inflation. What we’re trying to do is understand where the pricing of markets is assuming. And then we’re trying to look for a variety of scenarios where we’re saying, okay, under that scenario, this is kind of cheaply priced, but that’s expensively priced and making sure we have a variety of different assets in the portfolio. So, for us, it’s kind of never about predicting a scenario, but being aware of that scenario, if you like.

LaMonica: Okay. So, maybe just as an example, tariffs have obviously dominated the news and now they’re back with Trump and China and everything else. So, you did not come up with an opinion whether tariffs would, when he tweets, are going to be 100% on China. You don’t come up with opinions saying, oh no, we actually think they’re going to be 50%. You will just obviously see how the market responds.

Rose: We won’t come up with where we think it will land, but what we will come out with is, okay, who do we think are the winners and losers and do we think that’s reflected in prices? And a lot of the time, if the market’s already reacted, there is no opportunity for us to trade. But if the market has overreacted to a tariff announcement, for instance, on a US apparel company or that sort of thing or a semiconductor company, then we might say, okay, we think that this may have this effect, but not necessarily this long-term effect to the cash flows. And so that’s how we think about it.

LaMonica: You’re looking for – I think a lot of people are probably familiar with the efficient market hypothesis, which means that obviously the market is perfectly pricing in everything. You’re looking for inefficiencies.

Rose: We’re looking for inefficiencies, but not necessarily on having a different opinion to the market, but it’s more a different opinion on the time horizon. So, we’re using time horizon quite often behaviorally as our difference. So, the market is reacting today and acting like that’s the permanent future. And we might think, okay, but in three years’ time, that’s not going to be the case. And so, we use time horizon and that behavioral overreaction to predict things rather than, oh, we think the tariff is going to be 50% versus 100% or those things. We might have a sense for where we think probabilistically wise, because we think these are the things that realistically could happen over a long term. But again, we’re trying to use some behavioral and time horizon things more.

LaMonica: Okay, great. Well, we’ll let you get back to monitoring your 300 different slices of the market. I’m sure that takes some time, but thank you very much for joining us. We really appreciate it.

Rose: Thank you, Mark.

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