Optimization for strategic asset allocation involves the forecasts of at least three types of information:
- Expected returns of different asset classes
- Expected risk (volatility) of different asset classes
- Correlations of different asset classes
We recommend that investors avoid recency bias. Since the expected returns of all assets classes vary over time, we estimate expected return of an asset class by combining the following information:
- Long-term historical average return over multiple economic cycles
- Key drivers of historical returns and market forecasts of future performance of such drivers
- Consensus estimate of reputable wealth management companies
Investors may be inclined to take the long-term average return of an asset class as the expected future return. Such an approach likely will not work as the market environment mid 2017 is substantially different from the average of the past decades. Instead, historical returns give us information on the range of the possible returns. More importantly, historical returns help investors understand the key drivers that have determined realized historical long-term returns.
The following equation shows one way to decompose S&P returns:
- S&P return = equity risk premium + long-term bond return + noise
The first two terms explain the expected return:
Expected S&P return = equity risk premium + long-term bond return
= equity risk premium + short-term interest rate + term premium
= equity risk premium + (inflation + real short-term interest rate) + term premium
The last term explains the volatility in S&P returns. It is a random variable centered around zero.
We expect the inflation rate to stay at low level in the future as it did in the past decade. The real short-term interest rate depends on the Federal Reserve’s policy. In recent years, Federal Reserve has kept short-term interest to be below inflation rate. We do not expect dramatic policy change. The term premium depends on investors’ long-term view on economic growth. Market consensus is that the U.S. economy will grow at an average of ~2% in the next decade. All these factors indicate long-term bond returns are likely to be below historical average. As a result, return of S&P is likely to be below historical average as well. Consensus view: Estimates from wealth management firms suggest an expected return of +6%.
You can now compare and contrast your own views across +50 asset sub-classes with others.