Content provided by Joseph Smith, CFA – Senior Market Strategist
- Formulating return expectations is an important component of disciplined investing.
- Return expectations often fall prey to being unadjusted for risk.
- At CLS, we evaluate return expectations (CLS Edge Score) after adjusting for risk via Risk Budgeting.
Being a disciplined investor requires an expectation of what is likely to happen in the future. Many practitioners have taken multiple approaches to forming return expectations for a given asset class, sector, or region in the markets. Return expectations are intended to guide investors as to where the best opportunities (on average) may lie.
One of the biggest problems regarding return expectations is that some investors fall prey to evaluating these outcomes without acknowledging the uncertainty or associated risk. A sector that has the potential to generate a 10% return on paper could look on par with a risk-laden region that has an exact same 10% return expectation.
To tackle this challenge, we look hard at opportunities by first aggregating our return expectations based on interest rates, valuations, fundamentals, technical, and changes in risk into what we often refer to as the CLS Edge Score. From there, the CLS Edge Score is adjusted for the degree of associated risk via our Risk Budgeting Methodology. This gives us a much better gauge as to whether or not the potential reward is worth the risk and what capital we should choose to outlay.
Looking at our return expectations today, the best opportunities are primarily abroad in international and emerging market equities, not the U.S. In fact, Asia represents well over double-digit gain opportunities even when the Risk Budgets are factored in. Within emerging markets, the Asia-Pacific region presents the best opportunities for superior risk-adjusted returns.
Investors should keep in mind that risk-adjusted return expectations are the keys to properly evaluating the markets. Accounting for risk in any part of the investment decision-making process can help ensure a much smoother ride for clients in the long term. We accomplish this by marrying our work on the CLS Edge Score with our Risk Budgeting Methodology.