New Here? Get the Free Newsletter

Oblivious Investor offers a free newsletter providing tips on low-maintenance investing, tax planning, and retirement planning. Join over 9,000 email subscribers:

Articles are published Monday and Friday. You can unsubscribe at any time.

Using Historical Returns to Predict the Future

Historical financial data can be a useful tool. It can confirm common sense ideas such as the concept that stocks should usually earn more than bonds, and that bonds should usually earn more than cash.

And it can be used to find flaws in plans — as William Bengen did in his famous 1994 study, which found that you’re setting yourself up for trouble if you spend from your retirement portfolio at a rate equal to its historical average return.

But it’s easy to get into trouble by using specific historical figures as a tool for predicting the future.

Which Figures Should We Use?

According to my 2012 edition of the Ibbotson SBBI Classic Yearbook, the annualized after-inflation return for U.S. stocks from 1926-2011 was roughly 6.6%.* And the inflation-adjusted return for U.S. Treasury bills over the same period was roughly 0.6%.

So, if we’re trying to pick a number to use for average stock returns for the future, should we use the 6.6% real return figure? Or should we expect the more stable figure to be the 6% equity risk premium (that is, the difference between stock returns and Treasury bill returns)?

If it’s the risk premium that we expect to be more stable, given how low interest rates are right now, that would give us an expected real return for stocks of just 4.1%.**

And according to a paper from the Credit Suisse Research Institute, from 1900-2012, the global equity risk premium was just 4.1%. So going forward, should we be projecting based on the historical equity risk premium in the U.S.? Or should we be using a global average? Using that 4.1% figure would give us expected inflation-adjusted stock returns of just 2.2%.

The World Changes

In statistics, you learn about a given population by studying a sample of the population. And the larger your sample size, the more confident you can be in your conclusions about the underlying population.

With investing, the only way we can increase our sample size is to wait. For instance, if we’re concerned about annual U.S. stock returns, we have no choice but to collect that data at the glacial pace of one data point per year.

And a decent case can be made that the underlying population from which we’re drawing our sample is in fact changing over time, thereby reducing the usefulness of our older data points.

For example, in the 1930s, most U.S. households did not own stocks, placing a trade took several minutes and required talking to an actual person, trades were much more expensive, there were hardly any mutual funds (and no index funds or ETFs), nobody had up-to-the-second news, and the regulatory environment was entirely different.

So, if the purpose of our statistical analysis is to draw conclusions about what we can expect in the future, should we really be including results from the 1930s in our analysis? What about the 1940s? It’s not really clear where to draw the line.

Should We Ignore History?

My point here isn’t that history is useless. Rather, my point is that any time you encounter projections or conclusions based on historical figures, you would be well served to maintain your skepticism. In many cases you will find that there are alternative ways to interpret and apply the historical data that would lead to different conclusions.

*”Stocks” meaning the S&P 500 and the S&P 90 prior to the creation of the S&P 500.

**Calculated as 0.1% Treasury bill yield, plus 6% risk premium, minus 2% inflation (based on the market’s apparent expectation of roughly 2%, calculated as the spread between yields on short-term TIPS and nominal Treasuries).

New to Investing? See My Related Book:

Book6FrontCoverTiltedBlue

Investing Made Simple: Investing in Index Funds Explained in 100 Pages or Less

Topics Covered in the Book:
  • Asset Allocation: Why it's so important, and how to determine your own,
  • How to to pick winning mutual funds,
  • Roth IRA vs. traditional IRA vs. 401(k),
  • Click here to see the full list.

A Testimonial:

"A wonderful book that tells its readers, with simple logical explanations, our Boglehead Philosophy for successful investing." - Taylor Larimore, author of The Bogleheads' Guide to Investing

Comments

  1. garland whizzer says:

    Excellent analysis, Mike. Thanks.

    Garland Whizzer

  2. Good stuff, Mike. Of course it gets even more complicated when you try to use historical *data* to predict future returns. (i.e. Not even just use historical returns).

    I had the opportunity to chat briefly with one of the authors of the Credit Suisse report recently, and he expects the equity premium to be far lower for the foreseeable future, as a result of lower bond yields. He therefore thinks we should gird ourselves for much lower returns.

    In fact he’d suggest real returns much less than 4.0% from global stocks, and as for bonds, don’t look for anything much above inflation!

    I think he’s a bit too pessimistic, personally, and would note the unusual forces pulling down bond yields right now. But I’m not a prize-winning economist! ;)

If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
Disclaimer: By using this site, you explicitly agree to its Terms of Use and agree not to hold Simple Subjects, LLC or any of its members liable in any way for damages arising from decisions you make based on the information made available on this site. I am not a financial or investment advisor, and the information on this site is for informational and entertainment purposes only and does not constitute financial advice.

Copyright 2013 Simple Subjects, LLC - All rights reserved. To be clear: This means that, aside from small quotations, the material on this site may not be republished elsewhere without my express permission. Terms of Use and Privacy Policy