Capital markets assumptions are an estimate of the going-forward long-term returns for various asset classes or investments. For example, a firm might say they expect the US equity market to return an average of 7% per year over the next 20 years. Capital markets assumptions are a critical component of portfolio construction in wealth management but are now taking on an even larger role with the rise of financial planning.
Instead of using a one-size-fits-all approach like historical returns, some firms break the investible universe down into discrete asset classes and establish a separate estimation method for each. As a simple example, consider stocks and bonds. A firm could assign a valuation-based estimation method for stocks and a more mathematical method for bonds. Some asset classes even have long-term forward contracts that can be observed to determine what the market estimate for long-term returns will be.
Given the number of potential estimation methods available, we won’t go into them individually. Suffice it to say that they include valuation based, market based, mathematical, and even historical. We would like to rule out simply guessing, but we have seen that too.
#1 Good: Can incorporate current market conditions
The flexibility to choose more forward-looking estimation methods allows for the inclusion of current market conditions into the estimate. This overcomes one of the major disadvantages of the historical return method. Of course, it is still possible to use historical return as one of the estimation methods, if desired, but using current market conditions could help in a crash.
For example, if you adopt a valuation-based approach for the equity market, your equity return assumption will increase as the stock market decreases. If all goes well, you will have a much better time trying to hold your clients in the market during a crash because the increase in expected return will partially or fully offset the decline in value when looking out to retirement. It would be a great comfort to your clients to know that what you have been telling them all along is actually true: they will still be ok in the long run if the market crashes.
#1 Bad: More complicated
Depending on the types of methods chosen, this approach loses the simplicity and intuition of the historical returns method. Even if the individual methods themselves are simple and intuitive, the mere fact that the advisor must explain them all in order for the client to really understand what is going on makes it more complicated and prone to confusion/anxiety/lack of trust.
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