The Role of Capital Market Expectations
Capital market expectations represent the forward-looking prospects regarding the risk and return characteristics of the various asset classes. One of the critical components of any investment program is the strategic asset mix, hence, the need for market expectations to be set across the asset class spectrum. What are required are objective forecasts free of bias that are internally consistent.
A framework for this process would be:
1. Outline which asset classes expectations is required and over what period. Check the investment policy to see which asset classes are considered appropriate. Then list the required expectations, namely expected returns, standard deviations, and correlations.
2. Assess the historical record to understand the ranges that can occur, and the drivers of return or the factors affecting it. Information would be collected and could be divided into segments to cover different regions, sectors, etc.
3. Decide on methods and/or models that are to be used to set expectations. These may vary depending on the time horizon of the investor (some models are more effective at long-run forecasting).
4. Establish what sources will be used for the required information. The data needs to be understood since it may contain biases or errors that need to be considered.
5. Interpret the current environment given the data and methods to be used. Judgment will have to be exercised as part of this process.
6. Finalize the set of expectations.
7. Monitor the actual outcomes, compare them to the expectations that were set, and consider whether the process can be improved.