November 2022 / INVESTMENT INSIGHTS
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.
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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