Investment strategy: Long-term return and risk forecasts

Based on the investor profile discussed in Economico Flashes 14, 15 and 16, we are now getting down to business and focusing on a sensible composition of the investment portfolio. To do this, we need to have an opinion on the future return and risk behavior of the various asset classes. The big problem is that nobody – not even the self-proclaimed professionals – has a crystal ball. Institutional investors have therefore started to assess the return and risk potential of asset classes using different forecasting approaches in order to base allocation decisions on a broader foundation.

I would like to take you on a brief tour d’horizon – referring to the data presented in the illustration as of 31.12.2024 – beginning with return forecasts. All forecasts are based on a long-term horizon of five years:

• Historical average returns: Those relying on past averages assume pragmatically that the future will resemble the past. The problem is deciding which historical period should serve as the reference. Depending on the chosen time window, the resulting forecasts can differ considerably.
• Risk premium approach: This method adds a constant, category-specific risk premium to the risk-free interest rate (usually approximated by the yield of a 10-year government bond). The premium is estimated historically, which again raises the question of the appropriate time window.
• Consensus forecasts: Expectations are collected from as many market participants as possible and aggregated into an average or forecast range. The median of these consensus forecasts is used by Economico as the expected return for the standard portfolios.
• Fundamental forecasts: The fundamental approach measures the income potential of asset classes: yield to maturity for nominal assets, earnings yield for equities and net cash-flow yield for real estate.

To forecast future risk behavior, historical average fluctuations are summarized using volatility measures that can be calculated both for individual asset classes and for portfolios. Here too, the choice of the underlying historical period has a decisive impact on the resulting forecasts.