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.
One approach to estimating Capital Markets Assumptions is to apply macroeconomic principals to the process of estimating future returns. Broadly, there are two main types.
The first is a building-block approach where you start with a base return, which is generally the risk-free real rate of return. Then, you add inflation to get the risk-free return including inflation. Finally, you work up a series of appropriate risk/liquidity premiums for each asset class and add those. This results in a set of returns that tend to increase as risk increases and/or liquidity decreases in some hopefully sensible proportion. There is a good deal of arbitrage theory tied up in this, but most people accept the axiom of “more risk, more reward” at least in the long run.
The second is the full-blown macroeconomic model. This involves complex computer models of all the intricate relationships between various macroeconomic factors and markets. The result can be a massive global macroeconomic model with tens of thousands of inputs similar to a weather model, except people are more comfortable with the longer term forecasts than the shorter term ones.
#1 Good: Highly Robust
Academics use the word "robust" when they are concerned about using the word "accurate." From an academic standpoint, this is robust with a capital “R.” If you are impressed with PhDs and intensive study, and I think we can all admit to this at least a little, then this is the method for you. It is hard to argue that there isn’t at least some value in this level of pontification. And, while the wealth management industry is moving towards promoting greater client understanding and intuitiveness, there is a certain shock and awe associated with this level of effort that might connote value and expertise.
#1 Bad: Virtually Unintelligible
While unintelligible probably isn’t the right word, it still gets the point across. There is realistically no hope of a typical client having any real understanding or way to validate what is going on with these methods. This means reverting to the standard “trust us” approach. Unless you have an excellent and trusting relationship with your client, no internal understanding can lead to anxiety, which can then lead to inaction.
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