Swedroe: Expected Vs. Realized Returns

April 05, 2019

Summary

The evidence makes it clear that estimating future equity returns isn’t a simple task. If it were easy, we would be able to do what no one has yet been able to do well persistently—forecast stock market returns with a high precision.

Because we must develop financial plans without the benefit of a clear crystal ball, we should use the best tools available. However, when using these tools, the evidence demonstrates that we should have a healthy skepticism as to the accuracy of forecasts. We must be careful not to treat outcomes from models in a “deterministic” fashion. Instead, we should treat outcomes only as the mean of a very wide potential dispersion of possible outcomes. As an example, I’m not aware of anyone who in 1990 predicted that, through 2018, Japanese large-cap stocks would produce a return of 0.00% over the 29-year period.

Another important takeaway is that your comprehensive investment plan should include options you will exercise if the equity risk premium turns out to be less than expected. You need to list actions you will take to prevent your plan from failing to meet its primary objective—having your assets outlive you.

 

Appendix

 

The table provided is for illustrative purpose only. Expected returns assumptions are based on statistical modeling and are therefore hypothetical in nature and do not reflect actual investment results and are not a guarantee of future results.

In all five cases we examine here, the annualized realized returns were inside the acceptable range. In addition, the average error was just 0.9%. Taken together with the results from 2003 through 2009, we have 12 cases, each with returns within the acceptable range and an average error of just 1.6%.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

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