The Portfolio Solutions 30-Year Market Forecast

Investors expect to be paid for taking financial risks. The greater the expected risk, the greater the expected return. We periodically analyze the long-term risks of asset classes, styles, and categories, and from that data develop estimates for long-term market returns.

Risk Based Methodology

There is a basic premise that is universal among investors. Riskier asset classes are expected to deliver higher long-term rates of return. If you can estimate the risk in an investment, you can also estimate the return require of that investment relative to all other investments. 

A three-month Treasury bill have basically no risk. A twenty-year Treasury bond has interest rate risk. As such, we know that over the next twenty years the rate of return on a twenty-year Treasury bond is going to be higher than a T-bill return. The difference in return on the twenty-year bond is called “term risk premium”.

Instead of buying a twenty-year Treasury bond, an investor may decide to invest in a twenty-year “A” rated corporate bond. Unlike the Treasury bond, corporate bonds are not guaranteed by the U.S. government. As such, a “credit risk premium” is expected on the corporate bond.

Common stocks also have more risk than Treasury bonds and therefore are expected to generate a higher returns than T-bonds. The extra return is known in academia as the “equity risk premium”. 

The table below is our median expected return for all major equity and fixed income markets risks over the next thirty-years. It is a guide, not an absolute.

Thirty-Year Estimates of Bonds, Stocks, REITs, GDP, and Inflation

Index	Nominal Forecast	Inflation Adjusted	Risk*
US Treasury Bills (3 month annualized)	3.5	0.5	1.5
US Treasury Notes (5 year maturity)	4.5	1.5	4.8
Long-term US Treasury Bonds	5.5	2.5	8.0

Investment Grade Corp. Bonds (5 yr)	6.0	3.0	5.0
Long-term Corporate Bonds (A rated)	6.5	3.5	8.5
High Yield Corp.Bonds (B to BB)	7.5	4.5	14.0

US Large Stocks	8.0	5.0	17.0
US Small Stocks	9.0	6.0	20.0
US Value Stocks (low price-to-book)	9.0	6.0	20.0
REITs (Real Estate Investment Trusts)	8.0	5.0	17.0

International Developed Country	8.0	5.0	17.0
International Small Value	10.0	7.0	25.0
International Emerging Markets	10.0	7.0	25.0

Gross Domestic Product	6.0	3.0	2.0
Inflation (Consumer Price Index)	3.0	-	1.5

*The estimate of risk is the estimated standard deviation of annual returns.

Laddering Risk Premiums

Another way to look at asset class expected returns is by layering of risks premiums. As you go down the list in the table below, each asset class has the premiums of the asset class or category above it, plus a new risk premium. Adding risk premium layers derives an asset class expected return.

	Inflation	T-Bills	LT Govt.	LT Corp	Large Equity	Value Equity	Small Value Equity
Inflation	3.0%	3.0%	3.0%	3.0%	3.0%	3.0%	3.0%
Real Risk Free Rate		0.5%	0.5%	0.5%	0.5%	0.5%	0.5%
Term-risk Premium			1.5%	1.5%	1.5%	1.5%	1.5%
Credit Risk Premium				1.0%	1.0%	1.0%	1.0%
Equity Risk Premium					2.0%	2.0%	2.0%
Value Risk Premium						1.0%	1.0%
Size Risk Premium							1.0%
Total Expected Return	3.0%	3.5%	5.0%	6.0%	8.0%	9.0%	10.0%

No one knows exactly what the returns of the markets will be over the next thirty years. However, the risk in an asset class are fairly stable over time, and that tends to drive the long-term risk premium. 

The acceptance of a market forecast is an important step to creating a proper asset allocation. The forecast should always try to err on the conservative side. It is wise to expect and plan for lower returns and then be pleasantly surprised if the forecast is too low than to rely on a rosy forecast and possibly run out of money later in life. As the saying goes, it is better to be safe than sorry.

© 2008 Portfolio Solutions, LLC