Are Equity Return Forecasts Too Pessimistic?

Investment managers produce annual equity return forecasts, and the consensus is much more pessimistic than that of academics. I’ll take a closer look at why the forecasts are so different and the implications for advisors working with clients.

The most important assumption in financial planning is the future portfolio return, and future stock returns are the most uncertain component. The most structured way of creating stock-return forecasts goes back to the Graham and Dodd dividends-plus-growth approach. Roger Ibbotson has been the key academic researcher in refining the Graham and Dodd model, and his work over the past 20 years with other researchers has produced long-term forecasts of stock returns that are close to historical averages.

However, prominent investment managers’ forecasts are much lower, and I will explain why.


Before getting into the forecasts, we need to sort out some confusion over return definitions. There are a variety of ways to calculate returns and, unfortunately, those making predictions often fail to be precise about what they are forecasting. We hear predictions like, “I expect stocks to average about 9%.” But we don’t know if this prediction includes dividends or just reflects price appreciation. Is this a nominal return (including inflation) or a real return with inflation removed? Further, we don’t know if this predicted “average” is a simple average of future yearly returns (an arithmetic average) or if it is based on a compounding of future yearly returns (geometric average).

It’s straightforward to explain returns with and without dividends and nominal versus real returns, but forecasters often leave out their assumptions for dividends or inflation, and this creates confusion. For example, if one wants to convert a nominal return forecast to the underlying real return, there’s the question of whether to subtract historical inflation (about 3%) or market-based forecasts of future inflation (about 2%). This will depend on how the forecaster originally built their forecast, which may not have been stated.