February 5, 2020

Long-Term Equity Returns – A Reasonable Expectation

As we begin the new decade, I thought this would be a good time to consider what a reasonable long-term equity return expectation might look like.

While not particularly helpful for short-term strategies, setting long-term expectations has several benefits for investors including:

  • Long-term planning – Equity return expectations are a key building block for long-term investment planning.
  • Behavior – Purposeful focus on long-term investment horizons can help offset the emotional reaction to market volatility.
  • Modeling – The process of building an equity return expectation can help us think more objectively about the sources of equity returns.

As a first step, it is helpful to gain some perspective by reviewing the past three decades of equity returns.

Table 1: Three Decades of Average Annual Equity Returns

[table id=4 /]
Source: Dimensional Returns: Data: U.S. – Russell 3000 Index, Intl Developed – MSCI EAFE Index, Emerging Market – MSCI Emerging Markets


The next step in the process is choosing a forecasting model.  One model that I consider instructive is the Grinold, Kroner Model (GK Model).  Proposed in a 2002 paper, The GK Model views stocks returns as a combination of returns supplied by stocks.

The model decomposes the components of equity returns into three parts:

  • Cash flow return (i.e. dividend)
  • Growth component
  • Repricing (i.e. change in valuation)

As an example of the approach, we can use the model to decompose the average annual return on the S&P 500 Index.  From 1926 – 2001, the average annual return on the S&P 500 was 10.7%.  The GK Model enables us to break down this return into its component parts:

  • Cash return = 4.4%
  • Growth (real plus inflation) = 1.7% + 3.1% = 4.8%
  • Repricing (average annual change in the price/earnings multiple) = 1.5%

We now have the tools to build a reasonable long-term equity return expectation.

Cash Return

Cash return is a combination of dividend yield and net share buybacks.  While one can debate the best measure of the cash return, we can create a reasonable estimate assuming a lower bound of the dividend yield and an upper bound of the earnings yield (the inverse of the price/earnings multiple, E/P).

We can then split the difference between the upper and lower bound measures to generate a reasonable cash return estimate.


For the real growth component, we can use expected real GDP growth estimates as a proxy.  Combined with an estimate of expected inflation, we have our growth component.


Repricing is admittedly the trickiest part of this exercise.  Without any particular insight into whether equities will become cheaper or more expensive going forward, a reasonable approach is to assume a stable multiple of earnings for equities and so we use a zero value for repricing in the model.

Fifth Set long-term global equity expected return expectation

Using the GK Model framework, we can build a reasonable long-term global equity return expectation.


Table 2: Long-Term Global Equity Expected Return Expectation

[table id=5 /]
Source:  Vanguard – Current Cash Return, U.S. VTI dividend yield/earnings yield (1.8%/4.4%), International Developed – VEA – dividend/earnings
yield (3.3%/(6.3%), Emerging Markets – VMO – dividend/earnings yield (3.5%/7.1%) as of 12/31/19. International Monetary Fund – Real Growth and
Inflation – 2024 estimates as of October 2019


We can derive some interesting implications from the model’s inputs.  For instance, the model helps us see why economic growth is not solely responsible for differences in expected returns.  The table data show that while the economic growth and inflation estimates are similar between U.S. and international developed, the higher cash yield (i.e. relative cheapness) of international developed equities drives a higher expected return then U.S. equities.

The model’s results offer us reasonable long-term equity return expectations both as compared to historical returns and based on current expectations for the return components. We can use these expectations to help drive smart long-term investment plans, reduce the emotional impact of market volatility and gain a better understanding of the source of equity returns.