We should to be familiar with the historical rates of return on different asset classes in order to have an idea of what to expect in the future. Certainly, past returns have very limited predictive power, and have tremendous variability; nevertheless, they serve as both a guide to the past average returns and the riskiness of the different classes of assets. The data comes from the Federal Reserve Bank of St-Louis and Federal Reserve Bank of Minneapolis. Professor Damodaran of the Stern School of Business at New York University calculated returns on stocks, treasury bonds, and treasury bills based on the raw data from the Federal Reserve

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Historic returns are of important but rather theoretical value: we don't invest "for ever." At some point we withdraw funds – whether to supplement our retirement income, to pay for education or a house, etc. Here we present three time series: the average returns realized during a 5-year holding period, 10-year and 15-year holding periods. As could be expected, the 5-year averages are the most volatile and end up with negative returns more often than 15- and 10-year long holding periods.

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An article by Professor Malkiel, the author of the seminal 1973 book, A Random Walk Down Wall Street. In the book Malkiel argues that markets are efficient, absorb all new information very quickly, do not have "information memory," and in general do not allow investor to use perceived inefficiencies to earn above-normal returns. Here Professor Malkiel analyzes several theories critical of the notion of the efficiency of the stock market. Among the theories he examines in this article are "momentum theory," "overreaction," "January effect," and size-and value effects. In every case he concludes that none of these phenomena provide a way to earn above-normal risk-adjusted returns. Malkiel also offers an interesting discussion of the October 1987 crash and the Internet bubble of the late 1990s. Finally, Malkiel provides an excellent analysis of performance of actively managed funds vs. index funds and finds that, taking into account survivorship bias, active funds on average under-perform index funds. Moreover, there is very little predictability in the performance of funds: "hot" funds are as likely to turn into "underachievers" as any other funds.

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Standard and Poor’s keeps a scorecard of the performance of active funds vs. index funds. Here is the latest information covering the last five years. Again, the statistics indicate that, overall, index funds outperform actively managed funds, especially in the long run.

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So what could be expected in the future? Of course, it’s impossible to predict future performance of the stock market, but we believe that it’s instructive to follow the logic of economists as they attempt to rationalize our expectations. Professor Shoven of Stanford University prepared the following article for the Social Security Advisory Board. He breaks the future returns into two components: one, attributable to the future payments of dividends, and another, to the growth rate of the dividends. He then analyzes the fact that corporations transfer wealth to shareowners not only via dividends but also through stock repurchases. Shoven then investigates the future P/E ratios and their relationship to the steady-state level. He comes to a conclusion that the future stock market real returns will be on the level of 6 to 6.5 percent. It should be noted that at the time the article was written (2001) P/E was at 24. Given that currently it is below 20, perhaps Shoven would’ve been even more optimistic, were he to revise his article today.

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