Capital Market Assumptions - A Primer

9 min read
September 10, 2018

Projecting future returns is challenging. No matter how brilliant the source, they’re rarely accurate. But that doesn’t mean we should just throw our hands up and not care. It simply means we should educate ourselves and find the “least incorrect” way to project future returns. Here is how we attempt this at XY Investment Solutions (XYIS).

There are many reasons investors might try to project future returns for their portfolio.  For most of us, our goal is to guide clients to ensure their asset allocation decisions align with the assumptions in their financial plans. 

For instance, if a plan is expected to succeed with a future rate of return of 5%, the advisor should ensure that the client’s portfolio has a mix of investments that can be reasonably expected to produce the required return over the planning period.

The Big Picture: Many planners get hung up on capital market assumptions. We get it. You want them to be accurate. But IF you are working with clients in an ONGOING planning relationship, it’s reasonable to suggest that each time you “re-run” your plan analysis, it will change.

The challenge is that projecting future returns for assets is extremely difficult and fraught with potential errors, especially due to our inability to know the future. So then, given many asset managers publish capital market assumptions, and we need something on which to base our planning, what are we supposed to do? How are we supposed to know which one is going to be right, and which numbers to use?

Expectations, Assumptions, and Predictions

First, let’s define some terms. To us, expectations and assumptions go together. We expect and assume stocks will produce higher returns than bonds over the long run. If we don’t, then we probably shouldn’t be in this business because the whole thing is about to come unglued.

That said, we accept the fact there will be periods of time when that relationship might not hold, but it is nearly impossible to predict when stocks will underperform bonds. It is equally difficult to accurately predict specific rates of returns for discrete time periods.

Therefore, we prefer the terms “return expectations,” “capital market assumptions,” or “projections” when discussing the financial planning use case above, and refrain from using the term “prediction” at all in practice. Furthermore, the more precise we try to be in our expectations, the more they start to resemble predictions, so we would advise restraint from putting too much emphasis on the detail.

We suggest not that you should be totally reliant and faithful in the numbers you encounter, but rather that you should understand enough about them, and about how capital markets work, to know if they are reasonable and how to use them appropriately. Keep in mind, this is a blog post, not a submission to the Nobel committee, so we are going to keep it pretty light.

A Word of Caution: Planners are inherently cautious. And often they exude this caution on their clients. If you are adjusting capital market assumptions too conservatively, you stand to cause your client to SACRIFICE much of their life and happiness today. Unless leaving a large legacy is your client’s goal, be sure to consider this as you adjust your capital market assumptions downward.

Building Off the Risk-Free Rate

The risk-free rate is a theoretical rate of return we might expect from a risk-free investment. Dating back to 1979, the return on a 3-month Treasury bill (which is pretty much risk-free) has been around 4%.

It stands to reason that if you want to achieve a better return, you will likely have to take more risk. Why? Well, a company may be very creditworthy, but without taxing authority and other powers vested in the US Treasury, there is a non-zero percent chance they might default on their debts (bonds), so investors (bond buyers) are going to demand a higher return than the risk-free rate to buy one. For reference, the investment-grade bond market as a whole has returned approximately 7% since 1979, or about 3% per year more than the risk-free-rate.

Continuing with our discussion, if we remember that bond-holders rank higher than stockholders in corporate financing, then it only makes sense that investors will demand a higher rate of return from stocks than they will from bonds, all else equal. Since 1979, the S&P 500 stock index has returned approximately 12% annually, 8% higher than the risk-free rate and 5% higher than bonds.

If you simply used historical returns in your plans, you might be inclined to think you could meet any return requirement between 4-12% by allocating among these three categories. While that might be defensible logic, it might also do your clients a disservice and set them up to fail.

Today the 3-month T-Bill is paying 2%, and the bond market’s yield to maturity, widely recognized as a reasonable estimate for bond returns, is around 3%. We must conclude, then, that it is unlikely that the past for these two categories (cash and bonds) is any kind of indication of what the future looks like. Instead, an estimate of <2% for cash and 3% for bonds seems logical. I would call into question anything deviating too far above these figures.

Furthermore, there is no reason to believe that the extra return stockholders require will not be based off the lower expected returns of either the risk-free rate, or of bonds, because presumably their relative riskiness is no different now than in the past, at least from a capital finance perspective.

By that rationale, we should consider a reasonable long-term expected return for the S&P 500 of either 2%+8%=10% if based off cash or 3%+5%=8% if based off bonds. A mid-point of 9% seems like a good reference point, and it would not be unreasonable to err on the conservative side in your practice. Unfortunately, we all know there are unscrupulous “advisors” out there who use higher expected returns to paint rosier pictures to win more business; we must fight the good fight and hope the trusting public sees through the smokescreen.

For the sake of brevity, let’s agree that various parts of the market (large versus small, US versus non-US, etc) may have different expected returns, and that stock returns might be influenced up or down based on current valuation metrics. It doesn’t change the logic above. It just means you may have to apply it to more components of your portfolio.

Going back to our planning discussion, if your client requires a 5% rate of return, and you believe our capital market assumptions above are reasonable, then you’ll want to at least allocate 30% of the portfolio to stocks and the rest to bonds. Feel free to check the math.

In Practice

Many of the financial planning tools on the market today, such as RightCapital, eMoney, and MoneyGuidePro, have their own built-in assumptions, calculations, and methodology. It is important for users to understand how the tools they are using arrive at the conclusions they rely on for decision-making. It is equally important to know what the output can (and can’t) tell you, and to make sure not to be overly reliant on or overconfident in it.

At a minimum, we encourage you to make sure you know whether your toggle is set to historical or projected returns, understand how they are derived, and decide whether you agree or if adjustments need to be made in your process. 

Within the XYIS complex, you will find two distinct data points you might use: the “Expected Return” for each model allocation on the Fact Sheets, which we derive from RiXtrema and those calculated by our partner, RobustWealth, on their Wealth Projection. Because they use very different calculations, we find it acceptable that they are different. We’ll take this opportunity to dive more into RiXtrema, their calculations, and how to use them because more advisors utilize the Fact Sheets with clients.

RiXtrema derives a long-term price appreciation estimate for equities using historical market returns from studies by Deutche Bank and Thornburg, then adjusts for dividend yield and individual security betas. They use a conservative approach based upon yield to maturity for bonds, citing the fact that using historical returns would likely result in overstating forward-looking estimates, as we alluded to above. Detail is available upon request. 

Pro Tip: Clients always want to know “how will this / has this performed.” This is tough to answer when each client’s portfolio is personalized. Even when using model portfolios, each client’s experience is different based on a variety of factors. Here is the language we use on our portfolio fact sheets:

“Each portfolio is designed for you. Sure, we use the same building blocks but your portfolio is yours and yours alone. The portfolio will be tailored for you based on the personal values and goals set forth in your plan. However, your portfolio should behave in line with the index return expectations below, based on your target allocation.”

For XYIS advisors who would like a different or more elaborate approach to capital market assumptions, or at least some additional reference points, we suggest reviewing those from the investment companies used in our models, though by no means can we vouch for their accuracy:

Blackrock’s interactive tool is especially useful:

As is this overview from Vanguard:

It’s easy to see there’s a lot going on when it comes to capital market assumptions. But if we could leave you with just one takeaway it is this: as long as you are engaged in an ongoing planning relationship with your clients, regardless of the capital market assumptions you institute (within reason), your clients will be well positioned for the future.


Because plans change. Markets change too. But as long as you continue to guide your clients to great decisions, you can be “least incorrect” and still have a dramatic impact on your clients’ lives.


About the Author

Mario Nardone, CFA

Partner, East Bay Investment Solutions

Mario began his investment career in 1999 with Vanguard mutual funds in Valley Forge, PA, where he consulted institutions and financial advisors on investment policy, portfolio construction, and Exchange-Traded Funds (ETFs). He also held roles as a research analyst, a municipal bond fund specialist, among others during his tenure. In 2003 he earned the Chartered Financial Analyst designation, and he continues to mentor aspiring Charter candidates and young investment professionals.

Mario relocated to Charleston in 2010 to serve as Chief Investment Officer for a financial planning firm before establishing East Bay, the collaborative partner firm of (insert firm name), in 2014. As a Partner at East Bay, Mario serves a select group of Registered Investment Advisor firms as their outsourced Chief Investment Strategist. Responsibilities of this role include continuous oversight of advisor clients’ investments, bespoke strategies for unique situations, client communications, and more.

Mario is Past President of CFA Society South Carolina and Former Chairman of the College of Charleston Finance Department Advisory Board. His approach to investments and the industry has been featured in Investment News, NAPFA Advisor Magazine, South Carolina Public Radio, and other publications and media outlets.

Mario enjoys early morning basketball games, the Charleston beaches and restaurant scene, and spending summers in coastal Maine. He is an avid world traveler and SCUBA diver, but also enjoys the simpler joys of life with his wife Piper, their daughter Pepper, and son Santino.

Learn more and connect with Mario on LinkedIn.

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