Portfolio Design: A Modern Approach to Asset Allocation

RECONSIDERING STOCK RETURNS

The collapse of equity prices beginning in 2000 has led many investors to revise their estimates of long-run equity returns. In place of the optimistic estimates of high double-digit returns so characteristic of the late 1990s, some investors now envisage returns on equity equal to or even below those on fixed income.11 If equity returns are this low in the future, there will have to be major revisions of long-run investment plans. Endowments and foundations will have to adopt significantly lower spending rules, and corporate pension funds will face increased funding costs. Individual investors will have to scale back their retirement plans.

As in the case of bond returns, it’s instructive to look at historical returns, especially in periods prior to the bull market of the 1980s and 1990s. Table 2.2 reports average real compound returns over several past periods. The two-decade period from 1981 to 2000 saw unusually high real compound returns of 11.7 percent. No wonder that by the late 1990s, the expectations of investors had become so inflated.

Table 2.2 reports two sets of returns prior to the bull market. The first set of returns begins in 1951, like many estimates in this chapter, and ends in 1980. The second set of estimates begins in 1926 and ends in 1950. The two sets of estimates are remarkably similar, at least as far as the real returns are concerned. Without the bull market of the post-1980 period, the real return on stocks is 6.3 percent ...