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Alternative Methods for Projecting Equity Returns: Implications for Evaluating Social Security Reform Proposals: Technical Paper 2003-08

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  • John Sabelhaus
  • Joel V. Smith
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    Abstract

    The effect upon future Social Security benefits resulting from the introduction of individual accounts depends on both the potential risks and returns of private equities, yet the historical evidence about determinants of stock market risks and returns is mixed. In particular, correlations between equity returns and market fundamentals (such as the dividend price ratio) are weak at annual frequencies, which has led some to conclude that a random returns (fixed mean and variance) model is the preferred specification for simulating the future path of equity returns. Although choosing between random returns model and models based on market fundamentals do equally well for explaining variation of equity returns in the short run, the distinction is important when projecting equity returns over longer periods, as shown here in the context of a Monte Carlo simulation of Social Security reform. If equity returns are even weakly correlated with market fundamentals then (1) the expected future average return may be a function of the starting values for market fundamentals, and (2) the overall range of cumulative outcomes is more narrow than the random returns model suggests.

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    Bibliographic Info

    Paper provided by Congressional Budget Office in its series Working Papers with number 14678.

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    Date of creation: 01 Aug 2003
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    Handle: RePEc:cbo:wpaper:14678

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    1. Robert J. Shiller, 2002. "From Efficient Market Theory to Behavioral Finance," Cowles Foundation Discussion Papers 1385, Cowles Foundation for Research in Economics, Yale University.
    2. Burton G. Malkiel, 2003. "The Efficient Market Hypothesis and Its Critics," Journal of Economic Perspectives, American Economic Association, vol. 17(1), pages 59-82, Winter.
    3. Martin Feldstein & Elena Ranguelova, 2001. "Individual Risk in an Investment-Based Social Security System," American Economic Review, American Economic Association, vol. 91(4), pages 1116-1125, September.
    4. Ranguelova, Elena & Feldstein, Martin, 2001. "Individual Risk in an Investment-Based Social Security System," Scholarly Articles 2797440, Harvard University Department of Economics.
    5. Burton G. Malkiel, 2003. "The Efficient Market Hypothesis and Its Critics," Working Papers 111, Princeton University, Department of Economics, Center for Economic Policy Studies..
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