Why are expected returns so much lower than historical returns?

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willthrill81
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Re: Why are expected returns so much lower than historical returns?

Post by willthrill81 » Sat Apr 14, 2018 6:27 pm

gmaynardkrebs wrote:
Sat Apr 14, 2018 6:23 pm
HomerJ wrote:
Sat Apr 14, 2018 5:38 pm
bobcat2 wrote:
Sat Apr 14, 2018 11:05 am
But it is also possible that technological progress going forward will be disappointing, just as it has been over the last 50 years.
Actually, doesn't this prove the opposite of the pessimistic point?

If the last 50 years were indeed terrible for technological progress, yet we STILL got very good returns, doesn't that mean the idea that returns will be lower going forward (due to lack of progress) may be flawed?
If technology were the only factor, that would be one thing. But as I tried to point out when I started this discussion, after 1950 we were still benefiting immensely from the self inflicted wounds of Germany, UK, France, and Japan in WWII, and the Japan-inflicted wound on China, which led to another 40 years of insane Maoism in China. It's a lot easier to win a race when the runners you are competing against have knee-capped themselves..
How does that explain the 7% real returns experienced by U.S. equities since 1992 (when CAPE crossed its historic average and essentially never looked back)?
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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bobcat2
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Re: Why are expected returns so much lower than historical returns?

Post by bobcat2 » Sat Apr 14, 2018 6:41 pm

HomerJ wrote:
Sat Apr 14, 2018 5:38 pm
bobcat2 wrote:
Sat Apr 14, 2018 11:05 am
But it is also possible that technological progress going forward will be disappointing, just as it has been over the last 50 years.
Actually, doesn't this prove the opposite of the pessimistic point?

If the last 50 years were indeed terrible for technological progress, yet we STILL got very good returns, doesn't that mean the idea that returns will be lower going forward (due to lack of progress) may be flawed?
The last 50 years were not terrible for technological progress, they simply weren't nearly as good as the previous 50 years. (That was the best half century by far for technological progress in human history.) What's odd though is because of the IT revolution many people believe overall technological progress was extremely fast since 1970. It wasn't. The point here with regard to investing returns is we can't depend on high returns in the future on account of a sure thing of great technological progress in the coming decades. It could resemble the rapid period between 1920-1970, or the relatively disappointing progress since 1970. We simply don't know how fast technological progress will be in the coming decades.

BTW, market returns were significantly faster from 1920-1970 then they have been since 1970 and that despite the fact that the earlier period included the Great Depression and WWII.

1920-1970 8.2% annual return
1970-present 6.5% annual return

BobK
In finance risk is defined as uncertainty that is consequential (nontrivial). | The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.

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HomerJ
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Re: Why are expected returns so much lower than historical returns?

Post by HomerJ » Sat Apr 14, 2018 7:06 pm

gmaynardkrebs wrote:
Sat Apr 14, 2018 6:23 pm
HomerJ wrote:
Sat Apr 14, 2018 5:38 pm
bobcat2 wrote:
Sat Apr 14, 2018 11:05 am
But it is also possible that technological progress going forward will be disappointing, just as it has been over the last 50 years.
Actually, doesn't this prove the opposite of the pessimistic point?

If the last 50 years were indeed terrible for technological progress, yet we STILL got very good returns, doesn't that mean the idea that returns will be lower going forward (due to lack of progress) may be flawed?
If technology were the only factor, that would be one thing. But as I tried to point out when I started this discussion, after 1950 we were still benefiting immensely from the self inflicted wounds of Germany, UK, France, and Japan in WWII, and the Japan-inflicted wound on China, which led to another 40 years of insane Maoism in China. It's a lot easier to win a race when the runners you are competing against have knee-capped themselves..
It it a race? Can only one country "win"?

I agree we did great 1900-1950 because we didn't have constant wars in our homeland like Europe did.

But why does that mean we have to do poorly now? Can't all other countries do as well as us instead? Why do we have to move down? Why can't they move up and match us?

In fact, during the 80s and 90s, the U.S. didn't have any advantage of World Wars going on in Europe. Yet we still did pretty good (and so did they).

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FIREchief
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Re: Why are expected returns so much lower than historical returns?

Post by FIREchief » Sat Apr 14, 2018 7:25 pm

A timely article for this discussion:

https://www.marketwatch.com/story/stock ... 2018-04-13
U.S. stock valuations are at multiyear highs — and multiyear lows
I am not a lawyer, accountant or financial advisor. Any advice or suggestions that I may provide shall be considered for entertainment purposes only.

Patrick584
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Re: Why are expected returns so much lower than historical returns?

Post by Patrick584 » Tue Jun 19, 2018 8:48 pm

willthrill81 wrote:
Sat Apr 14, 2018 10:56 am
Patrick584 wrote:
Sat Apr 14, 2018 10:45 am
Iliketoridemybike wrote:
Wed Apr 11, 2018 7:28 pm
Reversion to the mean. It’s just that simple. If history shows 9-10% returns and recent returns are 2x -3x times that, you have to have a period of below average returns to get back to average.
False. The concept of reversion to the mean is that by taking a larger sample size it will likely look more like the average because repeating data that similarly deviates from the average is less likely than data that is closer to the average. Your statement suggests that future data will be in the opposite direction of the average because of a memory effect which is not true.
"Reversion to the mean, also called regression to the mean, is the statistical phenomenon stating that the greater the deviation of a random variate from its mean, the greater the probability that the next measured variate will deviate less far. In other words, an extreme event is likely to be followed by a less extreme event."
http://mathworld.wolfram.com/ReversiontotheMean.html

However, there is no rule stating that stock returns have to "get back to average." In truth, good returns are usually followed by good returns, and vice versa with respect to poor returns (i.e. the momentum effect).
I believe you are not correctly interpreting the concept of mean reversion. The expected return of the stock market does not have memory - no “momentum”, no opposite days. If you are a 150 bowler and you bowl a 300, with the exception of the rare case of bowling another 300, your second game will have a high probability of bringing your average closer to your expected average. Mean reversion deals with independent events as described by your reference. I challenge you to show a statistically significant, meaningful, and reproducible difference in market performance based on the performance of previous periods.

ignition
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Re: Why are expected returns so much lower than historical returns?

Post by ignition » Thu Jun 21, 2018 3:57 am

I think in most cases in the past, people were overly pessimistic a priori about equity returns. It's very easy to imagine everything that can go wrong, especially if you watch the news often.

My (simplistic) take: the current PE is about 25. Even in a no-growth, zero-inflation world this implies stocks would return about 4% per year over long periods of time. So barring nuclear war, the destruction of America or the stock market going to a PE of 5 again, I expect a real return of about 4% over the next 20 years in the worst case scenario. Maybe this is too simplistic?

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willthrill81
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Re: Why are expected returns so much lower than historical returns?

Post by willthrill81 » Thu Jun 21, 2018 8:17 pm

Patrick584 wrote:
Tue Jun 19, 2018 8:48 pm
willthrill81 wrote:
Sat Apr 14, 2018 10:56 am
Patrick584 wrote:
Sat Apr 14, 2018 10:45 am
Iliketoridemybike wrote:
Wed Apr 11, 2018 7:28 pm
Reversion to the mean. It’s just that simple. If history shows 9-10% returns and recent returns are 2x -3x times that, you have to have a period of below average returns to get back to average.
False. The concept of reversion to the mean is that by taking a larger sample size it will likely look more like the average because repeating data that similarly deviates from the average is less likely than data that is closer to the average. Your statement suggests that future data will be in the opposite direction of the average because of a memory effect which is not true.
"Reversion to the mean, also called regression to the mean, is the statistical phenomenon stating that the greater the deviation of a random variate from its mean, the greater the probability that the next measured variate will deviate less far. In other words, an extreme event is likely to be followed by a less extreme event."
http://mathworld.wolfram.com/ReversiontotheMean.html

However, there is no rule stating that stock returns have to "get back to average." In truth, good returns are usually followed by good returns, and vice versa with respect to poor returns (i.e. the momentum effect).
I believe you are not correctly interpreting the concept of mean reversion. The expected return of the stock market does not have memory - no “momentum”, no opposite days. If you are a 150 bowler and you bowl a 300, with the exception of the rare case of bowling another 300, your second game will have a high probability of bringing your average closer to your expected average. Mean reversion deals with independent events as described by your reference. I challenge you to show a statistically significant, meaningful, and reproducible difference in market performance based on the performance of previous periods.
Momentum in financial markets is a widely documented phenomenon in the finance literature. Larry Swedroe has written about it extensively of late. Stock returns are far from memory-less. This is why most Monte Carlo simulations produce far more extreme events, both in terms of positives and negatives, than what would statistically be expected given the returns data we already have.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

jalbert
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Re: Why are expected returns so much lower than historical returns?

Post by jalbert » Thu Jun 21, 2018 10:51 pm

The equity risk premium is expected return in excess of the risk free rate. The risk free rate is very low today, so overall equity expected returns would be lower than historical averages.
Index fund investor since 1987.

gmaynardkrebs
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Re: Why are expected returns so much lower than historical returns?

Post by gmaynardkrebs » Fri Jun 22, 2018 5:43 am

jalbert wrote:
Thu Jun 21, 2018 10:51 pm
The equity risk premium is expected return in excess of the risk free rate. The risk free rate is very low today, so overall equity expected returns would be lower than historical averages.
In addition, it looks to me that the equity risk premium has narrowed in recent years, as stocks are perceived as less risky than they once were.

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