Everytime I use some financial calculators, they always ask me to enter estimated future return. And everytime, my knee-jerk reaction is always a frustrated "How do I know?!". Of course my second reaction is to enter 4-6% after inflation. That usually gets me thinking of the conventional wisdom of "8-10% market return" (before inflation).
My question is: where did this number come from and how did it get justified to estimate future return of equity investment?
I read many times about some studies that showed that the return of equities from 1800 - present was a consistent 8-10% before inflation. And from these studies, people in finance/financial media concluded that 8-10% is "reasonable" to predict future return on investment.
The trouble is for me, I think this kind of thinking is flawed.
First, I wonder how the "studies" got their numbers? Survivor bias is mentioned many times. To me, "survivor bias" means we should realize that we are talking about a specific case study and thus instead of concluding 8-10% return in general, we should conclude "if we invest in winning companies and hold this investment for decade(s) then history shows that we may get 8-10% return". But how easy it is to always buy winning companies/funds and hold them for decades? Choosing/holding such companies/funds is only easy in retrospect.
Second, these "studies" surveyed mostly US companies in US market. This "8-10% return" resulted during a period which US grew from a new nation to world's economical superpower. Again, that is a very specific time in history which makes this a "special case study". Will US grow from superpower to superpower^3 and will it affect the market return similarly? Should we invest in countries poised to be the next superpower to duplicate historical studies? (And which country anyway?)
Third, history can and has at times, repeated itself in similar circumstances. So is the market today is similar with the markets of the past? Is the economy today similar with the economy of the past? If they are 2 different circumstances then how can we conclude that history will repeat itself? When did history decide then it owes us 8-10% return when we can't produce a similar circumstance where it can repeat itself?
Can anyone put me at ease and show me (or point some books for me) that this magic number can be used reasonably to estimate future return? At work, if I say "We will have X flow since the pump will produce y pumping capacity", my boss will then ask me "How do you know the pump has y capacity?". I will certainly get in trouble if I say, "Well operators said that in the past 10 years the pump has been producing y". That answer would not be acceptable. My boss can say, "well, it could be a different pump, pump could be old etc. Find out what pump they intend to use and what exactly its capacity". Ok, it's long-winded but my point is that we do not use historical data in our work to estimate future production, we use present data that we know will still be applicable in the future (ie. you don't replace pump every year). I am having trouble at the thoughts that I am using "historical" data in my financial planning.
My naive concern is that you can't predict future return/or it's more of "vodoo magic" than exact science.
What do you think?
Jane
My question is: where did this number come from and how did it get justified to estimate future return of equity investment?
I read many times about some studies that showed that the return of equities from 1800 - present was a consistent 8-10% before inflation. And from these studies, people in finance/financial media concluded that 8-10% is "reasonable" to predict future return on investment.
The trouble is for me, I think this kind of thinking is flawed.
First, I wonder how the "studies" got their numbers? Survivor bias is mentioned many times. To me, "survivor bias" means we should realize that we are talking about a specific case study and thus instead of concluding 8-10% return in general, we should conclude "if we invest in winning companies and hold this investment for decade(s) then history shows that we may get 8-10% return". But how easy it is to always buy winning companies/funds and hold them for decades? Choosing/holding such companies/funds is only easy in retrospect.
Second, these "studies" surveyed mostly US companies in US market. This "8-10% return" resulted during a period which US grew from a new nation to world's economical superpower. Again, that is a very specific time in history which makes this a "special case study". Will US grow from superpower to superpower^3 and will it affect the market return similarly? Should we invest in countries poised to be the next superpower to duplicate historical studies? (And which country anyway?)
Third, history can and has at times, repeated itself in similar circumstances. So is the market today is similar with the markets of the past? Is the economy today similar with the economy of the past? If they are 2 different circumstances then how can we conclude that history will repeat itself? When did history decide then it owes us 8-10% return when we can't produce a similar circumstance where it can repeat itself?
Can anyone put me at ease and show me (or point some books for me) that this magic number can be used reasonably to estimate future return? At work, if I say "We will have X flow since the pump will produce y pumping capacity", my boss will then ask me "How do you know the pump has y capacity?". I will certainly get in trouble if I say, "Well operators said that in the past 10 years the pump has been producing y". That answer would not be acceptable. My boss can say, "well, it could be a different pump, pump could be old etc. Find out what pump they intend to use and what exactly its capacity". Ok, it's long-winded but my point is that we do not use historical data in our work to estimate future production, we use present data that we know will still be applicable in the future (ie. you don't replace pump every year). I am having trouble at the thoughts that I am using "historical" data in my financial planning.
My naive concern is that you can't predict future return/or it's more of "vodoo magic" than exact science.
What do you think?
Jane