Occam’s Razor Redux: Establishing Reasonable Expectations for Financial Market Returns

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Reasonable expectations for capital markets returns are the foundation on which all investment programs are built. The model used to develop these critical expectations does not need to be complex. Rather, inspired by Sir William of Occam's Law of Parsimony, the authors review a model for developing reasonable expectations that was first articulated in a 1991 issue of The Journal of Portfolio Management. The model is simple and intuitive. The authors describe its effectiveness over the 25 years since the model was first applied and provide their view on reasonable expectations for stock and bond market returns in the decade ahead. They close by discussing the model's implications for investors and the financial sector.

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How do we formulate expectations for long-term returns on the asset classes involved in the SAA? One approach would be to rely exclusively on the historical record. We will look at this in the first section. Another approach is to base our expectations on more forward-looking indicators such as longer-term macro-fundamentals, models of return and valuations. We will look at how this applies to risk-free government bonds, credit and equities in the subsequent sections.
In ''Investing in the 1990s'' [Journal of Portfolio Management 1991], the author outlined a simple methodology for analyzing long-term total returns on financial assets using three components of return. A sequel, ''Occam's Razor Revisited,'' tested the methodology as a tool for forecasting ten-year financial market returns. With the decade of the 1990s now at the halfway mark, this article examines the accuracy of the author's forecasts, and presents some new perspectives on risk premiums and asset allocation.
The authors contend that most of the institutional investing community is expecting far higher returns than are realistic from current market levels. Extrapolating the past is the easiest, and worst, way to forecast the future. Unfortunately, most investors' return expectations are shaped by a simple extrapolation of either recent or long–term past returns. If, instead, the constituent parts of equity market returns are examined, we find that it is remarkably difficult to make a case for a positive equity risk premium (the premium of future stock market returns relative to bond yields) from current market levels. None of this analysis is contingent on any assumption that market P/E ratios or dividend yields should return to historical levels. If market levels are fair and are fully sustained in the years ahead, there is still little or no room for a positive equity risk premium. If there is not a positive risk premium, then actuarial return assumptions are likely to be too optimistic, with far–reaching im...