Reasonable Return Expectations

    TIP$TER, unlike practically every other popular retirement calculator or monte carlo simulator, is structured upon the concept of the equity risk premium.  TIP$TER assumes that an investor's portfolio is split and annually rebalanced between a basket of risk-free assets (e.g., TIPS) and a basket of risky assets (e.g., a total stock market index fund).  TIP$TER asks for two "return expectation" inputs: (1) the "real return on TIPS" (or the return on some other proxy for an risk-free asset of the investor's choosing), and (2) the "extra expected return on stocks" (or the extra expected return on some other basket of risky assets of the investor's choosing). 

    The "extra expected return" is a simple distillation of the "equity risk premium."  The "equity risk premium" (ERP) – the most important variable in financial economics – is nothing more than the difference between the expected total return on an equity index and the return on a risk-free asset.  To put it another way, the ERP refers to the additional expected return for stocks – to compensate for the risk – over the so-called "risk-free" rate.

    For an investor with a long planning horizon, the equity risk premium is the dominant factor driving the optimal stock/bond asset allocation split.  Nothing drives the relative attractiveness of stocks versus bonds as much as the equity risk premium.

    TIP$TER requires you to enter your forward-looking expected equity risk premium in the "Extra expected return on stocks" input.  For guidance on specifying this input, read the What is a Reasonable Equity Risk Premium? page.