Capital Market Assumptions - Part III
Median Returns and Mediocrity
One of the top software firms for registered investment advisors assigns a “Rate of Return” number (the median expected return) to each asset class of equity and fixed income categories. It also assigns a “Rate of Return” number to diversified portfolios. And because this is common practice throughout the industry, it has been adopted by most registered advisors and trust officers. However, this is misleading – at best.
In contrast, The Moneyball Method not only rejects “rate of return” characterization, but objective investors replace it with a radical alternative, meaning fundamentals and root causes.
First, the median return occurs in only a small minority of potential outcomes. Nearly all of them are measurably higher or lower and many of them by a lot. In technical terms, it ain’t gonna happen. Second, we do not predict the future of capital market performance, we anticipate the behavior of capital markets based on the objective, historical evidence.
But there’s more. This firm publishes the standard deviation of these asset classes and diversified portfolios, which is good - that gives context to the “rate of return” number, but they do not publish the correlation coefficients for each asset class. That lacks transparency.
Given all of this, it’s easy to understand how “rate of return” numbers become widely misunderstood and misused by investors and their advisors. But if rates of return are not being used properly, how reliable are the simulations that employ that data?
Taken a step further, the last essay in this series made the connection between correlation and standard deviation as codependent variables: for a fund to be highly correlated to its asset class it must have the same level of volatility with the same causality. In concert with that, the long-run expected return of an asset class or diversified portfolio must also be highly correlated with its risk profile.
Why? Because money is not stupid. Prudent investors will only accept risk if the potential reward justifies the transaction. Prices are information that helps investors decide if the risk and reward dynamic is favorable. Furthermore, this is how markets become elegant. Elegant meaning simple, efficient, graceful genius.
It is my contention that the many efforts to denigrate the historical evidence with 1) Forward-looking assumptions, or 2) Recent historical data, or 3) Regime-based assumptions, all in the name of conservativism, is to violate the precepts of reliable simulations. And of capitalism itself.
The alternative is the elegant and radical approach: employ long-term historical data from the most reliable sources and use rolling returns to visualize future potential outcomes. To learn more, please click the link below:
https://www.amazon.com/Moneyball-Method-Middle-Class-Manifesto-Objective/dp/1696009111/