Defined Benefit
Defined Contribution
Insurance Assets
Nonprofit

Capital Markets Assumptions and the Future

Capital Markets Assumptions and the Future
clock
2 min 43 sec

“It is difficult to make predictions, especially about the future.”
— Danish Proverb

At the end of every year, Callan updates our long-term capital markets assumptions. These projections for return, risk, and correlation are used to inform the strategic planning process for all of our clients. Their main purpose is to help clients design efficient portfolios. They are also used to form expectations for 10-year total portfolio returns to assist in a variety of planning exercises.

It is on this second score that we will focus today. The question that we often get from clients is, “How have you done in the past when predicting the future of the capital markets?” The short answer is, “not too badly.” The longer answer is shown in the chart below.

GregChart[1]

This graph goes back to our projections in 1989 and examines the record of Callan’s 10-year forecasted returns for a simple portfolio made up of 60% global equity, 30% U.S. fixed income, and 10% U.S. real estate. The bottom axis has two labels. The top numbers represent the year in which the forecast was made. The bottom numbers represent the ending date for the ensuing 10-year period.

The orange line represents the mid-point for our forecasts for each 10-year period. The area between the two light green dashed lines represents a range of +/- one standard deviation around the mid-point and is based on our projected standard deviation numbers for the sample portfolio at the time. Finally, the teal line represents the actual performance that was generated by the portfolio over the ensuing 10-year period.

This chart provides several valuable lessons that can benefit institutional investors as they assess how to understand and use capital markets assumptions. First of all it shows that our projected returns for this portfolio have been on a steady decline since 1989. This is a reflection of a secular drop in inflation expectations, bond yields, and the equity risk premium.

Secondly, and more pertinent to this discussion, the chart illustrates that our projected returns have generally been within one standard deviation of the actual return experienced over the subsequent period (albeit erring on the low side more often than the high side). The glaring exceptions are the 10-year periods ended in 2008 and 2009.

Unique to these two periods is the fact that they each contained not one but two major collapses in the equity market: the Dot-Com Bubble in 2001-02, and the Global Financial Crisis in 2008. Individually each of these collapses represented a 2-3 standard deviation event on the downside. When they are included in the same 10-year period, they completely overwhelm the projection numbers that we (and our clients) were working with 10 years earlier.

To me the key takeaway from this exercise is that capital markets projections (ours and those of our peers) are generally good for describing a range of reasonable potential outcomes for a diversified portfolio. They are not, however, especially good at making point estimates of the return for any given 10-year period, especially when it includes a catastrophic financial crisis. This makes them effective tools for designing efficient portfolios and for simulating the risk of financial variables. When it comes to predicting the future, however, perhaps George Will summed it up best when he said, “The future has a way of arriving unannounced.”

Posted by

Share
Share on facebook
Share on twitter
Share on linkedin
Related Posts
Defined Benefit

When the Passive Index Is an Active Decision

Weston Lewis
Because of differences in passive indices, investors should understand how the one they choose will affect benchmarking.
Defined Benefit

SEC Division of Examinations Issues ESG Risk Alert

Thomas Shingler
The Division issued the Risk Alert to 1) communicate its observations from past examinations and 2) address the Division’s areas of focus during upc...
Defined Benefit

Equities Off to a Strong Start; Inflation Fears Haunt Bonds

Kristin Bradbury
U.S. equities outpaced global stocks in 1Q21. The 10-year U.S. Treasury yield hit its highest intraday yield in 15 months during the quarter.
Defined Benefit

2021—Starting Off with Gusto!

Kristin Bradbury
How the economy did in 1Q21, and the outlook ahead.
Defined Benefit

What We Found in Our Latest COVID-19 Survey of Investment Managers

Amy Jones
The 3rd edition of our Coping with COVID-19 survey of investment managers focuses on plans for office reopenings and vaccination policies.
Defined Benefit

The Gray Areas in Green Bonds

Kristin Bradbury
A common challenge for those investing in green bonds is that there is no uniform set of requirements or standards. This makes analysis and monitoring...
Defined Benefit

The Story Behind Callan’s 2021 Capital Markets Assumptions

Capital Markets Research
An explanation of Callan's 2021-2030 Capital Markets Assumptions, how they were developed, and what changed from last year's projections.
Defined Benefit

GameStopped—Or Just Getting Started?

Jim McKee
A key issue highlighted by GameStop is the unintended consequences of zero-cost money and commission-free trading enabled by today’s highly stimulat...
Defined Benefit

Relief Bill Provides a Shot in the Arm to Corporate Pensions

William Emmett
The $1.9 trillion economic relief bill included another round of pension funding relief that reduces required, tax-deductible contributions for single...
Defined Benefit

Bloomberg Barclays Pricing Time Change and What It Means for Institutional Investors

Kyle Fekete
Asset owners, investment managers, and other parties may experience discrepancies in reporting point-in-time pricing or performance as a result.