Swedroe: Assessing Expected Returns

October 13, 2014

‘Past returns don’t guarantee future returns’ isn’t even the half of it.

At a recent meeting with a nonprofit organization, my firm was asked to explain why we don’t consider historical stock returns the best estimator of future returns. They wanted to understand why we instead rely on our own forecasts.

Their request came in part because another firm had suggested in a previous pitch that forecasts using anything other than historical returns were nothing more than opinion.

I thought sharing our response to the question posed by the nonprofit would be helpful for investors in general. First, we completely agree that investors shouldn’t make decisions based on personal opinion. Rather, investment decisions should be grounded in applicable academic research.

But before discussing the literature, we should address the issue of whether using historical returns is a logical approach in the first place. The following example may provide some insight.

From 1926 through 1948, the S&P 500 produced an annualized return of 6.3 percent. Relying on the historical record would lead you to forecast a return of the same 6.3 percent going forward. From 1949 through 1999, however, the S&P 500 returned 13.7 percent. And the return over the full period, from 1926 through 1999, rose to 11.3 percent.

Common Sense?

Thus, relying on the additional information contained in the historical record would lead you to forecast a new current expected return of 11.3 percent. Let’s see if increasing your forecast from 6.3 percent to 11.3 percent because returns were 13.7 percent over the intervening period makes sense.

On Jan. 1, 1949, the price-to-earnings (P/E) ratio of the S&P 500 was 6.6. That’s an earnings yield (E/P) of 15.2 percent. On Jan. 1, 2000, the P/E ratio stood at 29.0, producing an E/P of 3.4 percent. Does it make sense to forecast a return of 6.3 percent when the E/P is 15.2 percent, and also to forecast a return of 11.3 percent when the E/P is 3.4 percent?

The answer should be obvious. Yet that’s what you would be doing if you relied on historical returns. Common sense—which is all too uncommon—should lead you to conclude that this isn’t logical. Higher prices paid for the same dollar of earnings should lead to a forecast of lower, not higher, returns. And the academic literature demonstrates that current valuations do, in fact, provide us with the best estimate of future returns.

The following is even a simpler and clearer explanation for why using historical returns is illogical. From 1926 through 2013, the return on long-term (20-year) Treasury bonds was 5.5 percent. At the beginning of 2014, the yield on the 20-year Treasury bond was 3.7 percent. Which is the best estimate of future returns, the historical return of 5.5 percent or the current yield of 3.7 percent?

Clearly, the answer is that the current yield remains the perfect predictor of the return over the next 20 years, at least in nominal terms.



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