This monograph examines how investors form return expectations across asset classes, combining market data, surveys, and behavioral insights to reveal the pitfalls of relying on past performance and guide more realistic forecasts.
Key Takeaways:
- Starting yields and valuations shape return potential. High valuations and low starting yields point to lower long-run expected returns.
- Past performance can distort expectations. Investors often extrapolate recent gains, creating a gap between their expectations and what market fundamentals suggest.
- Expectations vary across investors and markets. Institutional return forecasts and interest rate expectations tend to be less extrapolative, but even rational forecasts can miss the mark for years.
- Past returns can skew investor expectations. Investors may become overly optimistic about US equities and private assets and too cautious about liquid diversifiers.
Abstract
This monograph extends the expected returns literature by trying to understand how investors actually form long-run return expectations. It contrasts “objective” yield-based expected returns (which historically display some predictive ability) and “subjective” rearview-mirror expectations (which excessively extrapolate past 3- to 10-year returns or growth).
Objectively feasible expected returns are low when market valuations are high and starting yields are low. Yet, surveys reveal that the consensus expectations of some market participants (such as equity analysts and individual investors) can exhibit opposite behavior: naive extrapolation. The tension between objective and subjective expectations was most pronounced near market peaks (2000, 2021, 2025) and troughs (2009).
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The book focuses on macro assets rather than single-stock expectations—the US equity market from the perspective of historical average returns, forward-looking timing indicators, and survey evidence, as well as US Treasuries and the yield curve, plus alternative diversifiers. It also contrasts expectations formation among equity and bond market participants, as well as among institutional and individual investors.
The story is nuanced. Academics and practitioners may mean different things when they talk about expected returns. Some subjective expectations appear more rational and less extrapolative, such as those of institutions and those on interest rates. Even rational predictions work only on average, and they can fail for a long time.
Rearview-mirror expectations have made many investors too optimistic on risky and private assets after the good times that followed the 2008 Global Financial Crisis, and too cautious on liquid diversifiers. The dangers of a rearview-mirror mindset are most pronounced in the case of US equities’ outperformance compared with the rest of the world.