Formulating Capital Market Expectations
Capital market expectations are risk and return expectations regarding asset classes. Investors should establish long-term return and risk expectations for each allowable asset class specified in the investment policy statement (IPS). When formulating capital market expectations, investors should ensure that the expectations are internally consistent. This means that they should be both:
- Cross-sectionally consistent. This refers to consistency across asset classes regarding risk and return characteristics
- Intertemporally consistent. This refers to consistency over various investment horizons regarding portfolio decisions over time.
Seven-step process to formulating capital market expectations
Formulating capital market expectations can be done using a seven-step process. The steps are the following:
- Determine the specific capital market expectations needed according to the investor’s allowable asset classes and investment horizon(s). Time horizon is particularly important in determining the set of capital market expectations that are needed. Short time horizons imply that an investment in risky asset classes is not an option.
- Investigate assets’ historical performance to determine the drivers that have affected past performance and to establish some range for plausible future performance. Once the drivers of past performance are established, the analyst can use these to forecast expected future performance as well as compare the forecast to past results to see if the forecast is reasonable.
- Identify the valuation model to be used and its requirements. For example, a comparables-based, relative value approach used in the United States may be difficult to apply in an emerging market country.
- Collect the best data possible. The use of low quality data will lead to wrong conclusions. Financial publications and commercial databases are likely the best sources for reliable information on asset classes.
- Use experience and judgement to interpret current investment conditions and decide what values to assign to the required inputs. Verify that the inputs used for the various asset classes are consistent across classes.
- Formulate capital market expectations. Any assumptions and rationales used in the analysis should be made available.
- Monitor performance and use it to refine the process for setting expectations. If actual performance varies significantly from what was forecasted, the process and model should be refined further.
We discussed a number of criteria as well as a seven step process to formulate capital market expectations.