Projecting long-term returns on different asset classes is perhaps one of the most important skills an investor can have. All too often, investors simply extrapolate historical returns into the future. This practice can be dangerous as secular changes (anywhere from 10-50 years) have and do occur slowly in markets over time. For example, Japan's equity and fixed-income markets went through secular change after their equity bubble burst in the late 1980s. That event altered returns in those markets for a very long time.

Each of the three major asset classes - equities, fixed income and inflation-protected securities - has unique factors which influence their projected return.
Whether you are planning for retirement or overseeing a pension fund, correctly projecting long-term returns will help ensure your financial goals are met. Before looking at how to calculate projected returns on the three main asset classes, let's step back and look at historical returns and real return first.

An Historical Perspective
During the 20th century, the U.S. dominated both economically and financially (the U.S. equity market as a percentage of the world economy rose from an estimated 22% in 1900 to over 50% by 2000, according to a study called "Irrational Optimism" in the Jan/Feb 2004 issue of Financial Analysts Journal). As a result, equity returns and price volatility for the U.S. were more favorable than the world average during that period. But, just as Britain's economic dominance faded in the 20th century, the same fate could behold the U.S. in this century. As well, the most reliable and commonly used U.S. historical long-term returns (Ibbotson Associates) are from 1926, which is still a relatively short period from a statistical standpoint.

While U.S. equities have had positive real returns for every 20-year period in the 20th century thanks to political and economic stability, the same cannot be said for other countries. The economic and financial decimation from two world wars hindered the markets in Europe and Asia. Still, it hasn't been all smooth sailing in the United States. Between 1966 and 1982, the Dow Jones Industrial Average was knocked down by two-thirds in real terms, according to Bryan Taylor's "Skinning the Bear - History Lessons for the 21st Century Investment Managers" (Barron's, 2002). If it were not for the great bull market of 1982-2000, that 20-year rule for equities would not have held true. Let us now look at the steps involved in calculating projected long-term returns.

Focus on Real Returns
The first step of this process is to focus on real returns rather than on nominal (unadjusted for inflation) returns. Nominal returns are meaningless without an understanding of their underlying real returns. For example, would you rather have a 12% return with inflation at 10%, or a 5% return with 2% inflation? All else being equal, most investors would choose the latter since it would yield a real return of 3% as opposed to only 2% in the former. Inflation-protected securities (IPS) are the only securities today that guarantee a real rate of return (To read more, see Inflation Protected Securities – the Missing Link.)

Fixed Income: Easy to Calculate
The next step is to look at current interest rates. Historical U.S. fixed-income returns have been poor predictors of future returns since World War II. Until the 1960s, chronic inflation had never been a big problem in America. Investors, therefore, had never properly priced fixed income to take account for this risk.


Future returns are easily predictable for buy-and-hold fixed-income investors as yield curves exist in most countries for periods between 30 days and 20-30 years.
While not as easy, most bond fund returns are predictable because their portfolios tend to track indexes where a yield to maturity (YTM) is available. This YTM is a rough proxy of the index's performance over its average term to maturity. Capital gains can play a part in short-term fixed-income returns, but not over the life of a bond or bond portfolio. Also, be sure to deduct some percentage off your projected fixed-income return for the management expense ratio (MER). Particularly in a low interest rate environment, it is extremely difficult for fixed-income managers to add enough value to cover their MER.

Total Return-U.S. Fixed Income: Interest
12/31/04: 4.8%

Note: In order to compare apples to apples, a long-term government bond will be used for fixed income. In the U.S., this will be a 30-year Treasury. While equities are the longest duration security available (the cash flows they generate for investors can go on indefinitely), securities of similar durations should also be used for other asset classes when calculating a balanced portfolio's projected return. For fixed income, this would mean the longest duration bonds available.

IPS: The Link between Fixed Income and Equities
While arguably a separate asset class, no balanced portfolio should be complete without inflation-protected securities. They are poorly correlated with equities and fixed income and, therefore, enhance the risk-adjusted profile of a portfolio (see Inflation-Protected Securities: the Missing Link). The joy of IPS is that the real return is known upon purchase. Projected inflation is implied by the difference between a government bond and IPS of equivalent term.

Total Return-U.S. IPS: Real Rate of Return + Projected Inflation (Fixed Income – IPS)
12/31/04: 1.9% + (4.8%-1.9%) = 4.8%

Note: As you will notice, the projected returns for equivalent term fixed income and IPS are the same. This makes intuitive sense as projected inflation is the reconciling factor. However, their actual returns will likely differ as actual inflation deviates from projected inflation over the long term.

Equities: The Wild Card
The most difficult asset class to calculate projected returns for is undoubtedly equities. We need first to look at equity returns from an historical context.

Extrapolating historical real returns for equities can be risky. Factors now apparent were not evident in the early part of the last century. Firstly, dividends played a much larger part in historical returns back then. Secondly, valuation levels have risen materially over the past century. Future returns have historically been heavily dependent on initial valuations (see "Dow 5,000" by Bill Gross in the Sept 2002 issue of PIMCO's Investment Outlook.)

Thirdly, the quality of earnings can be a factor. For example, operating earnings and reported earnings started deviating from each other in the late 1980s (see Jeremy Siegel's "The Long-Run Equity Risk Premium," CFA Institute Conference Proceedings - Points of Inflection, 2004). As companies came under pressure to justify their rich stock valuations, they adjusted the definition of operating earnings in their favor. Therefore, rich valuation levels could be justified even further if operating earnings are used instead of reported earnings, which exclude both discontinued operations and extraordinary items.


As a result, 90% of real equity returns came from factors other than earnings growth during the 20th century - mainly dividends and valuation expansion, according to Gross.

Reversion to the mean is a powerful factor in the investment world. It has played out repeatedly through history with painful asset bubbles and drawn out corrections. The equity bubbles in the United States in 1929 and Japan in 1989 are two of the 20th century's most famous.

Looking forward, leading researchers on equity premium do not see the equity premium much higher than 2-3%, according to the "Irrational Optimism" report. (Also see The Equity Premium – Part One and Part 2.) Another justification for this lower equity premium is that it is much easier to obtain diversification and liquidity in the equity markets today than it was in the early part of the last century, Siegel says. This will, therefore, lower the risk of owning equities.

Total Return-U.S. Equities: Risk Free Asset + Equity Premium + Projected Inflation
12/31/04: 1.9% + 2.5% + 3.0% = 7.4%

Note: The best example of a risk-free asset in which to measure against equities is the longest maturing government IPS for a market. For the
U.S., this would be the 30-year TIPS.

Deciphering historical returns is the first step in understanding future returns. As you have seen, determining future returns for fixed income and IPS is an easier task than for equities. At the very least, these projected returns give you a base in determining the relative value of those three asset classes going forward.

The advent of IPS has allowed us to calculate the market's projected inflation for any term where there is an outstanding IPS. Before extrapolating historical equity returns in the future, you should take note of a few key points. One, dividend yields have been lowered dramatically over the past century. Two, changes in equity valuations have altered the starting point for the 21st century. Three, a lower equity premium is reasonable given your ability today to obtain a liquid, globally diversified portfolio.

All investment decisions involve some projection of expected returns. Art or science? You be the judge.

Note: The projected total returns (for real returns, deduct the 3% projected inflation) in this article are before fees and taxes and are based on a 30-year period. They can be calculated for any developed market with long-term IPS. Shorter periods can be used, but with more volatility around their projected returns.

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