Future market returns are uncertain, but estimating expected returns is an essential planning exercise for most investors. Here I will explore some new research that digs relatively deeply into this topic.
Return forecasts, commonly called capital market assumptions, impact investors in a variety of ways. The most obvious implication has to do with optimal portfolio design. Asset classes and investments with more attractive CMAs should receive higher portfolio weights than those with less attractive CMAs.
CMAs can (and should) also affect other financial decisions, such as how much a household has to save for retirement, can spend in retirement, etc. (i.e., a financial plan). Financial plans for households can exceed 50 years in length. For example, a 30-year-old might plan on retiring at age 65 and then having a retirement that would last until age 95, suggesting a 65-year planning period.
The returns used in this financial plan should be the expected returns for investors and can vary as expectations evolve into the future.
The Breakdown
While historical long-term average returns are commonly used by financial advisors, this approach can provide an unreasonable estimate of expected returns for investors today, especially for fixed income investors.
For example, the average yield on 10-year U.S. government bonds from January 1870 to July 2021 has been 4.5%, based on data from Robert Shiller's website. This is significantly higher than current yields, which are closer to 1.7% as of Oct. 21.
Any type of plan using historical long-term averages is likely to paint an overly optimistic picture for investors, resulting in lower required savings rates and higher available safe withdrawals, especially for investors with shorter time horizons (e.g. retirees).
While it's possible the gap between current and historical yields will narrow in the future, a financial plan whose return assumptions are based purely on long-term averages would imply an investor owning 10-year U.S. government bonds (before fees, taxes and inflation) today could effectively earn a 4.5% return. In reality the actual expected return, based on today's yields, is likely to be considerably lower.
