Modern Portfolio Theory and Investment Analysis, 9th Edition

10

Estimating Expected Returns

As discussed in earlier chapters, to implement modern portfolio theory, one must have estimates of future expected returns, variances, and covariances. Of these, the hardest to forecast is future expected returns. The valuation of a company's stock, as well as the valuation of the stock market as a whole, depends on the aggregate of all participants' expectations. Future returns are heavily dependent on how these expectations change over time. Because these expectations are unobservable, and there are so many diverse opinions, it is difficult to forecast the change in aggregate expectations. There is no magic formula for forecasting future expected returns. However, there are some general techniques that have proved helpful in the past. These are discussed in this chapter.

The chapter is divided into three sections. In the first section, we discuss forecasting return for asset categories like stocks or bonds. These forecasts are useful in aggregate asset allocation. In the second section, we discuss forecasting mean return for individual securities. In the final section, we discuss dealing with forecasts when the forecasts are discrete (e.g., buy, hold, sell) rather than continuous (e.g., expected return is 13.2%).

AGGREGATE ASSET ALLOCATION

Aggregate asset allocation deals with how much to invest in broad categories of securities. For example, in what proportions should an investor divide his assets among large capitalization stocks, international ...