Our last few posts on portfolio construction have simulated various weighting schemes to create a range of possible portfolios. We’ve then chosen portfolios whose average weights yield the type of risk and return we’d like to achieve. However, we’ve noted there is more to portfolio construction than simulating portfolio weights. We also need to simulate return outcomes given that our use of historical averages to set return expectations is likely to be biased.
In our last post, we analyzed the performance of our portfolio, built using the historical average method to set return expectations. We calculated return and risk contributions and examined changes in allocation weights due to asset performance. We briefly considered whether such changes warranted rebalancing and what impact rebalancing might have on longer term portfolio returns given the drag from taxes. At the end, we asked what performance expectations we should have had to analyze results in the first place.
In our last post, we took a quick look at building a portfolio based on the historical averages method for setting return expectations. Beginning in 1987, we used the first five years of monthly return data to simulate a thousand possible portfolio weights, found the average weights that met our risk-return criteria, and then tested that weighting scheme on two five-year cycles in the future. At the end of the post, we outlined the next steps for analysis among which performance attribution and different rebalancing schemes were but a few.
In our last post, we compared the three most common methods used to set return expectations prior to building a portfolio. Of the three—historical averages, discounted cash flow models, and risk premia models—no single method dominated the others on average annual returns over one, three, and five-year periods. Accuracy improved as the time frame increased. Additionally, aggregating all three methods either by averaging predictions, or creating a multivariate regression from the individual explanatory variables, performed better than two out of the three individual methods.
Over the past few weeks, we’ve examined the three major methods used to set return expectations as part of the portfolio allocation process. Those methods were historical averages, discounted cash flow models, and risk premia models. Today, we’ll bring all these models together to compare and contrast their accuracy. Before we make these comparisons, we want to remind readers that we’re now including a python version of the code we use to produce our analyses and graphs.
In our last post, we applied machine learning to the Capital Aset Pricing Model (CAPM) to try to predict future returns for the S&P 500. This analysis was part of our overall project to analyze the various methods to set return expectations when seeking to build a satisfactory portfolio. Others include historical averages and discounted cash flow models we have discussed in prior posts. Our provisional analysis suggested that the CAPM wasn’t a great forecasting model.
Over the last few posts, we’ve discussed methods to set return expectations to construct a satisfactory portfolio. These methods are historical averages, discounted cash flow models, and risk premia. our last post, focused on the third method: risk premia. Using the Capital Asset Pricing Model (CAPM) one can derive the required return for a particular asset based on the market price of risk, the asset’s risk, and the asset’s correlation with the market.
Our last post discussed using the discounted cash flow model (DCF) as a method to set return expectations that one would ultimately employ in building a satisfactory portfolio. We noted that if one were able to have a reasonably good estimate of the cash flow growth rate of an asset, then it would be relatively straightforward to calculate the required return. The problem, of course, is figuring out what the cash flow growth rate should be.
After our little detour into GARCHery, we’re back to discuss capital market expectations. In Mean expectations, we examined using the historical average return to set return expectations when constructing a portfolio. We noted hurdles to this approach due to factors like non-normal distributions, serial correlation, and ultra-wide confidence intervals. While we highlighted these obstacles and offered a few suggestions to counteract such drawbacks, on first blush it didn’t seem like historical averages were all that satisfactory.
We’re taking a break from our extended analysis of rebalancing to get back to the other salient parts of portfolio construction. We haven’t given up on the deep dive into the merits or drawbacks of rebalancing, but we feel we need to move the discussion along to keep the momentum. This should ultimately tie back to rebalancing, but from a different angle. We’ll now start to examine capital market expectations.