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 of the key components of financial planning is the projection of a client’s retirement savings balance in the future. While savings rate can be a critical input to this projection, the assumptions the advisor uses to project investment returns can be equally critical, depending on the horizon.
Since the future is unknowable, coming up with a sound prediction of future investment returns is a tricky business. It is also the sort of thing that causes compliance departments and legal disclaimer people to narrow their eyes and stare intently.
One straight-forward way to forecast investment return is to simply look at what the returns have been in the past. An advisor will typically use the average return over some appropriately long historical time frame, preferably encompassing at least one business cycle. Things like volatility and correlation can be calculated the same way, if required.
#1 Good: Simple and straight-forward
It seems that even investors with no financial training understand the notion of how an investment’s past performance could be a basis for predicting how it might perform in future despite the fine print that tells them exactly the opposite. This tends to give clients a point of validation that allows them to move forward with the rest of the analysis without too much in the way of anxiety.
#1 Bad: May contribute to panic in a crash
Apart from getting new clients, one of the toughest parts of an advisor’s job is trying to calm clients down when the market is crashing. Unfortunately, using historical returns makes that job much more difficult.
Consider the case of a stock market crash of around 50%. Just prior to the crash you provided your client with a financial projection showing they would have ample savings by retirement given their prior balance and your historical return assumption. Assuming that they were 100% in the equity market, that same analysis would show a significantly lower savings balance at retirement since they are starting from a much lower base and the return assumption is actually going lower as the recent market data points are incorporated into the average.
This can result in your client jumping to one of the following conclusions: you lied to them, you put them in the wrong portfolio, or the market is simply broken – probably all three. That’s a tough ledge to talk someone down from. Some of the other methods we will look at give you the ability to correct for this.
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