This article is sponsored by Hall O’Brien Wealth Counsel
Rolling the dice
What is a reasonable expected return from your portfolio? It’s a factor of a couple things: the amount of risk you are comfortable taking and the expectation of asset-class returns for the assets held in the portfolio. Consider the following scenarios where the goal is a 7.5 per cent gross rate of return (before inflation and before fees):
- In 1995, an investor could have an expected gross rate of return of 7.5 per cent with a moderate volatility of six, holding a portfolio of primarily cash and fixed income.
- By 2005, a portfolio with the same expected rate of return would have 50 per cent higher volatility – i.e. greater year-over-year variability in results and would be comprised of only 52 per cent fixed income and the remainder in equity investments.
- Ten years further on, in 2015, achieving a 7.5 per cent expected rate of return would involve a volatility of 17.2 or almost three times the 1995 portfolio and would hold only 12 per cent fixed income and the remainder in a variety of equity investments.
Chances are many people are not necessarily comfortable with that level of volatility. The good news is that risk can be mitigated by blending a portfolio to include asset classes with lower expected volatility and by holding a broader range of assets that react to the “market” (i.e. the equity market) differently and therefore, taken together, lower the volatility of the overall portfolio.
Expected returns for asset classes
To assign an expected return to each asset class, it’s useful to look at historical average returns.
For the 15-year period 2005-2019, large-cap equities returned, as measured by the S&P 500, nine per cent annually while bonds returned 4.1 per cent. A portfolio that included large cap, small cap, international, emerging markets and various fixed income instruments, meanwhile, returned 6.6 per cent annually. And the risk, or volatility, of the portfolio was 10 per cent versus 22 per cent for emerging markets equities, 17.7 per cent for small cap equities, 14 per cent for large cap equities and 3.4 per cent for fixed income.
However, future returns will be based on the market and economic conditions of the future and given our low-interest rate environment and increasing globalization and digitization of the economy, expectations of future returns are seven per cent for the S&P 500 and 3.3 per cent for fixed income.
A simplified 40 per cent fixed income/60 per cent equity portfolio can therefore be expected to achieve a gross return of 5.5 per cent going forward.
It’s also important to know whether investors are talking about nominal or “real” returns. Real returns take inflation into account and inflation averaged 2.1 per cent over the period 1998-2017. To provide real growth in a portfolio, it must earn enough to keep up with rising costs of goods and plus more.
Keep calm and carry on
“In only two years out of the last 80-odd years have returns of the stock market and the bond market both fallen within a close approximation of their long-run average. So, returns are rarely normal, and yet most people kind of use that as their base expectation of what should I be expecting from my stock and bond portfolio,” says Don Bennyhoff, senior investment strategist at Vanguard.
To summarize, it is in fact rare that any asset class, or portfolio, achieves its average return in any given year. It can take many years before returns reflect the target. The range of returns of the S&P 500 over a two-year period can be from -50 per cent to +50 per cent. Over a five-year period that range diminishes to -18 per cent to +38 per cent. Over a 20-year period, the range of total returns closes to zero per cent to 20 per cent. The longer you invest in the market and stay in the market, the better your chance of earning the average investment return.
So when the person beside you at the next (post-COVID) dinner party tells you their returns are 20 per cent or, at the other extreme, has “safely” tucked their money under the proverbial mattress, consider whether either of these approaches is realistic.
The 20 per cent returns likely come with extreme volatility that most investors would not be able to stomach, watching the value of their portfolios swing wildly up and down year over year. Further, most people would not be satisfied to sit in cash and watch their buying power, and by extension the ability to maintain their lifestyle, erode.
Rather than judging whether a portfolio did “well” based on whether or not it “beat the market,” investors should consider using a targeted rate of return based on their individualized or household tolerance for risk. If their financial plan is achievable using that targeted rate of return, what happens in the markets on a year to year basis will be of lesser concern.
If you’re looking for a way to maximize your wealth in a way that is tailored to your risk-tolerance, we are happy to meet with you and determine what asset allocation would be best for your portfolio and what your realistic rate of return would look like.
You can reach out to Shawna O’Brien via email at Shawna.OBrien@RichardsonWealth.com or 613-788-8027 to schedule a meeting.
This article is supplied by Joelle Hall of Hall O’Brien Wealth Counsel, Investment Advisor with Richardson Wealth.
Hall O’Brien Wealth Counsel specialize in tax-efficient portfolios and planning. We speak your language so you feel confident in the plan we implement together.
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