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What Are Long-Run Expected Real Returns?

Long-run expected real returns represent the anticipated increase in an investment's purchasing power over an extended investment horizon, typically a decade or more, after accounting for inflation. This concept is fundamental to Investment Analysis and Portfolio Management, guiding strategic asset allocation and long-term financial planning. Unlike nominal returns, which reflect the stated growth rate of an investment, long-run expected real returns provide a more accurate picture of how an investor's wealth might genuinely grow, enabling them to maintain or enhance their Purchasing Power over time.

History and Origin

The practice of forecasting long-run expected real returns is intrinsically linked to the evolution of modern financial theory and the increasing sophistication of capital markets. While investors have always sought to grow wealth, the formal consideration of "real" returns, adjusted for the erosion caused by Inflation, gained prominence as periods of significant price increases highlighted the inadequacy of focusing solely on nominal figures. Economists and financial practitioners began to develop models that incorporated factors beyond simple historical averages, acknowledging that future returns are influenced by prevailing economic conditions, demographic trends, and the starting valuations of assets. The formalization of these methodologies, often drawing on decades of market data, became crucial for institutional investors and pension funds tasked with meeting long-term liabilities. Research Affiliates, for example, publishes insights into various approaches for forecasting asset and portfolio expected returns, emphasizing a multi-component model that aims to improve out-of-sample forecasts⁴.

Key Takeaways

• Long-run expected real returns project investment growth after adjusting for inflation over extended periods.
• They are critical for strategic Asset Allocation and long-term financial planning.
• These expectations help investors understand the potential for their wealth to increase in terms of purchasing power.
• Unlike historical returns, which are backward-looking, expected real returns are forward-looking estimates.
• Forecasting long-run expected real returns involves complex models that consider various economic factors.

Formula and Calculation

The calculation of real return is derived from the nominal return and the inflation rate. While long-run expected real returns are more complex to forecast, the underlying principle of adjusting for inflation remains. The approximate formula for real return is:

$\text{Real Return} \approx \text{Nominal Return} - \text{Inflation Rate}$

For a more precise calculation, especially when dealing with higher rates or for academic purposes, the Fisher Equation provides the exact relationship:

$(1 + \text{Nominal Return}) = (1 + \text{Real Return}) \times (1 + \text{Inflation Rate})$

Rearranging to solve for the Real Return:

$\text{Real Return} = \frac{(1 + \text{Nominal Return})}{(1 + \text{Inflation Rate})} - 1$

Where:

• Nominal Return refers to the stated return on an investment before adjusting for inflation.
• Inflation Rate is the rate at which the general level of prices for goods and services is rising, and subsequently, purchasing power is falling.

Forecasting these variables over the long run requires sophisticated Valuation models that consider future economic growth, demographic shifts, and other macroeconomic factors influencing both nominal returns and inflation.

Interpreting the Long-Run Expected Real Returns

Interpreting long-run expected real returns involves understanding their implications for wealth accumulation and financial goal achievement. A positive long-run expected real return suggests that an investment is anticipated to grow faster than the rate of inflation, thereby increasing an investor's true Purchasing Power. Conversely, a negative long-run expected real return implies that an investment's value, after inflation, is expected to decline over time, leading to a reduction in wealth. These projections are crucial inputs for strategic Asset Allocation decisions, helping investors align their portfolios with their long-term objectives and Risk Tolerance. For instance, J.P. Morgan Asset Management publishes its Long-Term Capital Market Assumptions, providing insights into expected returns across various asset classes, which can guide institutional investment strategies³.

Hypothetical Example

Consider an investor, Sarah, who is planning for retirement 30 years from now. She wants to understand how much her diversified investment portfolio might realistically grow. Her financial advisor uses a long-run expected real return of 4% for her portfolio, based on a projected average nominal return of 6.5% and an average inflation rate of 2.5% over the next three decades.

Using the precise formula:
( \text{Real Return} = \frac{(1 + 0.065)}{(1 + 0.025)} - 1 )
( \text{Real Return} = \frac{1.065}{1.025} - 1 )
( \text{Real Return} \approx 1.03902 - 1 )
( \text{Real Return} \approx 0.03902 \text{ or } 3.902% )

This means that, on average, Sarah's investment is expected to grow by approximately 3.902% annually in terms of what it can buy, after accounting for the rising cost of goods and services. If Sarah invests an initial $100,000, after 30 years, her investment would be worth approximately $100,000 \times (1 + 0.03902)^{30} \approx $314,080$ in today's purchasing power. This calculation highlights the power of Compounding when considering real returns over long periods.

Practical Applications

Long-run expected real returns are central to several key aspects of financial planning and investment management. They serve as a cornerstone for determining appropriate Asset Allocation strategies, helping investors and institutions structure portfolios that are likely to meet future liabilities and goals in real terms. For pension funds, endowments, and long-term individual investors, these forecasts inform decisions about target Return on Investment and acceptable levels of Market Volatility. For instance, the Federal Reserve Bank of St. Louis provides data on real interest rates, which are a key component in understanding long-term real returns, aiding economic analysis and forecasting². These expectations also play a role in setting realistic withdrawal rates for retirees and in evaluating the long-term viability of various investment strategies, including those focused on Diversification across different asset classes within Capital Markets.

Limitations and Criticisms

Despite their critical role, long-run expected real returns are subject to significant limitations and criticisms. Forecasting future returns, especially over extended Investment Horizons, is inherently challenging due to the unpredictable nature of Economic Growth, inflation, and market events. Models used for these forecasts often rely on historical data, which, while informative, may not perfectly predict future outcomes due to evolving market structures, technological advancements, and shifts in global economic dynamics. As one article highlights, "the world is different than it used to be" and past performance is not a guarantee of future results¹.

Critics also point to the potential for bias and inaccuracy in such forecasts, particularly when they influence significant financial decisions. Factors like behavioral biases, unforeseen policy changes, or systemic shocks can significantly deviate actual returns from even the most sophisticated long-run expectations. The difficulty in predicting long-term Interest Rates and future Inflation further compounds the challenge. Therefore, while providing a necessary framework, long-run expected real returns should be viewed as estimates and not guarantees, requiring flexibility and periodic review in financial planning.

Long-Run Expected Real Returns vs. Nominal Returns

The distinction between long-run expected real returns and Nominal Returns is crucial for accurate financial planning and understanding wealth accumulation.

The confusion between these two terms often arises when investors focus solely on nominal gains, potentially overlooking the erosion of their Purchasing Power due to inflation. While nominal returns indicate the raw growth of capital, long-run expected real returns provide a more realistic measure of an investor's financial progress over time, especially relevant for goals many years in the future, such as retirement planning or funding education.

FAQs

Q1: Why are long-run expected real returns important for retirement planning?

A1: Long-run expected real returns are crucial for retirement planning because they help you understand how much your savings will actually be able to buy in the future, after accounting for the rising cost of living due to Inflation. This allows for more realistic projections of how long your savings will last and what lifestyle they can support.

Q2: How are long-run expected real returns estimated?

A2: Estimating long-run expected real returns typically involves sophisticated financial models that consider various economic factors, such as expected Economic Growth, future Interest Rates, corporate earnings growth, and anticipated inflation. These models often go beyond simple historical averages and incorporate current market Valuation levels.

Q3: Can long-run expected real returns be guaranteed?

A3: No, long-run expected real returns cannot be guaranteed. They are forward-looking estimates and are subject to significant uncertainty. Economic conditions, market performance, and inflation rates can deviate significantly from projections, making actual returns higher or lower than expected. Investors should view them as probabilistic forecasts rather than certainties.