Does the Mean Really Matter? Using Historical Rates of Return in Financial Planning Projections

Etheridge Jr., Riley O.
June 1998
Journal of Financial Planning;Jun98, Vol. 11 Issue 3, p113
Academic Journal
This article presents the author's opinion on using historical rates of return in financial planing projections. Ibbotson's Stocks, Bonds, Bills and Inflation 1997 Yearbook calculates the geometric mean on common stocks from 1926 to 1996 to 10.7 percent. It is this source, with the omnipresent chart that has been used to estimate future returns in optimization and financial planing projections. Even the greenest of stockbrokers and financial planners have this chart, and use it with clients in their presentations. The chart on page 12 of the 1997 Yearbook is not quite as popular, but perhaps it is far more important. Clearly, there have been several long periods where the return on equities has been quite different from the historical average. Any planning projection during those periods using the historical return would have been grossly inaccurate. However, as of June 1998, our profession has experienced no downside risk from these assumptions, equity returns for the 1980s and 1990s have been above average and exceeded expectations. Financial planning is an art, not a science. There is much that we cannot quantify or accurately predict. The financial plans and dreams of our clients will be greatly affected by the portfolio returns achieved in the future. It is our job to make their expectations of future returns more realistic, and to help prepare them for the uncertainty that they face. A simple reliance on the average return understates this risk, and will likely cause our clients to fail in their pursuit of their financial goals.


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