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Considering The Past And The Future In Asset Simulation

A systematic modelling process to simulate potential asset returns for portfolio construction

Modelling future expectations is a key component of portfolio construction that helps asset allocators to assess the risk and return of different portfolio designs.

We have developed an intuitive process to explicitly embed both long‑term historical asset behaviours and investor expectations of future performance when simulating asset returns.

Our three‑step process: (1) expands the market return history to cover multiple business cycles, (2) recalibrates historical returns with the investor’s forward‑looking expectations and (3) seeks to generate simulations that preserve the salient characteristics of asset returns. 

A robust portfolio construction process, overlaid with rigorous risk assessment, is crucial for designing and managing portfolios. Though challenging, it is important to properly assess the risk and return characteristics of various asset classes in different market environments, particularly when historical data are limited. Simulations are often used to analyse and stress‑test portfolios—however, the available simulation approaches have their limitations.

...the available simulation approaches have their limitations.

Two popular simulation approaches are Monte Carlo modelling and historical resampling (their definitions and details are explained below). Each approach has its advantages and shortcomings. At T. Rowe Price, we have developed a process that seeks to bridge the two methods by creating a historically informed but forward‑looking simulation. This process can not only exhaustively explore possible trajectories of asset performance under user‑defined return expectations, but also maintain important information gleaned from history, such as month‑to‑month asset movements and cross‑sectional volatilities over different market cycles.

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This material is being furnished for general informational and/or marketing purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, nor is it intended to serve as the primary basis for an investment decision. Prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources' accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date noted on the material and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request.  

It is not intended for distribution to retail investors in any jurisdiction.

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