Saturday, January 29, 2005

Long Term Expected Capital Market Returns


Traditional asset allocation mean variance optimization is performed based on a set of forward looking capital market inputs which include risk and return parameters. The capital market expectations are generally predicated on the theory that the more systematic risk is inherent in an asset class, the higher the expected return. The chart above provides a sample set of long term expectations that an actuary or investment consultant might use to do a formal asset allocation study. Notice the individual asset class characteristics as they move from southwest to the notheast quadrant, increasing risk and increasing return. The line in the chart is known as the "efficient frontier" and represents the array of portfolios which maximize forecast return for any given risk level (measured as standard deviation). Since these concepts and processes are used extensively, we would expect portfolios generated by these to be similar in rough proportion (taking into acccount other prudent constraints) and only as successful ex post( after the fact) as the underlying ex ante or forecast capital market assumptions. Go to the next Post.

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