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May 24, 2011 at 05:45 AM
The 2008 market tailspin has put enormous pressure on advisors to better understand asset allocation strategies and risk management. Sophisticated and forward-looking modeling of capital markets assumptions is the foundation for building stronger portfolios, assessing their risk, and making Monte Carlo forecasts. Virtually every portfolio construction or modeling tool uses some form of capital markets forecasts. Some evaluate risk/return expectations based on long-term historical trends alone. Others anticipate potential volatility over a longer time horizon.
Some advisors are content to rely on traditional, historical-based forecasting methods. Others are ready to make a rigorous evaluation of their current methodology to determine if it is equipped to assess extreme long-term volatility. Understanding what you are using to determine your forecasts and believing in their validity are the first steps in establishing a foundation for portfolio construction.
Whatever an advisor’s stance, he or she needs to at least do some window shopping, armed with the list of categories required for testing any capital markets assumptions modeling tool. These categories include the following:
- Expected returns
- Standard deviations
- Correlations
For each category, ask the questions below to review the proposed assumptions and their underlying rationale.
Expected Returns
- How does the modeling tool/software formulate expected returns?
- If the numbers are based on historical data, do you believe the historical period used will resemble the period of time on which they are based?
- Do you have confidence in the numbers?
- Have you compared the forecasts to other available forecasts sources, such as
