Having historical data can be a good place to start in your journey of understanding how an investment behaves. That said, investors may want to be leery of extrapolating past returns for the future. Historical data is a guide, it’s not necessarily predictive.
Another limitation to the expected returns formula is that it does not take into account the risk involved by investing in a particular asset class. After all, investing can be inherently risky.
And risk and return are often two sides of the same coin. In order to achieve a higher rate of return, you’ll most likely have to take more risk. The risk involved in an investment is not represented by its expected rate of return.
Look at the first example. In this example, which uses historical returns, 9% is the expected rate of return. What that number doesn’t reveal is the risk taken in order to achieve that rate of return. The investment experienced negative returns in the years 2005, 2006, 2012, and 2014. The variability of returns is often called volatility.
Sometimes, investment risks and managing them come with the possibility of losing money. Knowing this, it might be misguided to assume that 9% annual returns were going to show up as positive 9% returns each and every year. To achieve 9% average returns, there must be some risk involved.