Portfolio Design: A Modern Approach to Asset Allocation

UPPER AND LOWER BOUNDS FOR EQUITY RETURNS

Investors making decisions about saving rates for retirement need to form estimates of future equity and bond returns. Investors already beginning retirement need to form such estimates in order to set spending rates in retirement. With such a wide variation between estimated returns, how are investors going to make informed decisions about future returns on their portfolio? Perhaps it is most sensible to use the estimates of real returns discussed above to set upper and lower bounds for expected equity returns.

Investment plans should be based on compound real returns, not arithmetic averages. That’s because these plans are designed to last for decades or more. So the averages reported in Table 2.3 must be converted into compound long-term equivalents. Fama and French develop what they call long-term estimates of real stock returns derived from arithmetic averages. (Their methodology is explained in the appendix). Table 2.4 reports long-term estimates using the same methodology for the period from 1951 to 2007. Two estimates are provided, one based on actual capital gains and the other based on earnings growth.

TABLE 2.4 Alternative Estimates of Long-Run Real and Nominal Stock Returns (Based on 2.5 percent Inflation Rate), 1951–2007

Data Sources: The dividend and earnings data are from www.econ.yale.edu/∼Shiller and the stock price data from Bloomberg.

Real Compound	Nominal Compound Averages
Averages based on	Averages	(based on 2.5% ...