History or Forecasts: What’s Better in Making Return Projections?
It can be really hard to make a prediction that comes true. Just ask pollsters and meteorologists. And that principle holds true regarding returns on retirement accounts and investments.
Christopher Carosa in FiduciaryNews examines
which is better when making retirement return projections: looking at historic returns or making economic forecasts.
The key, Carosa argues, is determining which is more reliable. “Therein lies the awful rub in terms of fiduciary liability. Whichever path is chosen requires sound reasoning behind the choice,” he writes. And the stakes, he cautions, can be high, noting: “for a fiduciary, that means “defensible” reasoning, the kind that can stand up to judicial scrutiny.”Historic Returns
Practitioners, Carosa says, use the information contained in historic returns in different ways. “Historic return data,” he writes, represent “a convenient and inarguable ‘comfort’ zone for the typical fiduciary.”
One reason he cites for that is that “it quickly and easily shows investors the different risk/return characteristics of the various asset classes.” Another is that they can show real-life consequences of various investment strategies. And they can be helpful in determining risk tolerance and in setting clients’ expectations.
There are caveats to the use of historic returns, Carosa points out. For instance, he notes, one should account for sample errors — and failure to do so could result in forecasts that are more optimistic than they should be. Some practitioners, on the other hand and perhaps at least in part to guard against that, make more conservative projections.Economic Forecasts
Using economic forecasts, says Carosa, “provides another source of return data that can broaden the understanding of the variance of potential returns.” In addition, they can be used as a “stress test” to gauge wiliness to face risk.
One way to use economic forecasts, Carosa says, “is to better assess the sequence of return risks. The historic data provides examples of what happens if you retire at the wrong time, but it’s not helpful on a forward looking basis. That’s where economic forecasts might offer their greatest value.”Be Careful!
Carosa offers some notes of caution regarding the use of historical records and economic forecasts.
For example, there’s the watchdog and regulatory role the federal government plays through agencies such as the Securities and Exchange Commission (SEC). And one of the SEC mandates with which many are familiar is the disclaimer “Past results do not guarantee future results.”
He also suggests being careful when using market timing, the practice of using investment strategies based on the belief in the existence of some form of timing advantage as it relates to a particular strategy rather than based on fundamental analysis.