Time to rethink expectations

“What kind of returns can I expect?”

Whenever I discuss investing with a reader or new client, that question almost always comes up. After all, anyone setting out to build a retirement portfolio needs to have some expectation for long-term performance. These days, most people seem to think 6% or 7% annually (before inflation) is a reasonable target for a traditional mix of stock and bond index funds. Some shoot for even more. Earlier this year, the McKinsey Global Institute reported that many pension fund managers in the U.S. assume they’ll earn 8% annually on a balanced portfolio.

If you have a short memory, you might be forgiven for such optimism. A simple Couch Potato portfolio of 40% bonds and 60% equities (split evenly between Canadian, U.S. and international stocks) did, in fact, return between 6% and 7% annually over the last 10- and 20-year periods. And shorter-term returns have been close to 10% a year over the last three years.

Investors: Don't do dumb stuff when it gets hard

Humans are wired to expect recent trends to continue, and clearly many investors are banking on similar gains in the future. They should sober up. McKinsey’s report (Diminishing Returns: Why investors may need to lower their expectations) provides a useful reality check. The authors point out that 1985 through 2014 was “a golden era for investment returns.” During these three decades, stocks in both the U.S. and Western Europe enjoyed an annualized real return—that’s after accounting for inflation—of 7.9%. Meanwhile, real bond returns were 5% in the U.S. and 5.9% across the pond. (In Canada, the figures were 6.4% for stocks and 6% for bonds.) That’s far better than longer-term averages. The researchers believe these glory days aren’t likely to be repeated.

Today, a traditional bond index exchange-traded fund (ETF) with an average term of about 10 years has a yield to maturity of about 1.7%. With a five-year GIC you can stretch that to 2% or so.

Returns on equities are impossible to predict, but the McKinsey researchers point to several factors that have changed since the “golden era,” including lower inflation, lower interest rates, slower economic growth and slimmer corporate profit margins due to greater competition. They suggest that over the next 20 years these trends could reduce real returns on stocks to between 4% and 5% a year. In a balanced portfolio you’re looking at an expected return of roughly 5% before inflation or about 3% in real terms.

It’s interesting to contrast this with newly updated guidelines from the Financial Planning Standards Council, which administers the Certified Financial Planner regime in Canada. (I hold this planning designation and pay dues to the FPSC.) Their guidelines for equities are similar to those in the McKinsey report, but their fixed-income expectations seem a tad optimistic. Assuming 2.1% inflation, the FPSC suggests that planners project returns of 4% for bonds and 3% for cash.

To be fair, planning guidelines are designed for long-term projections. If your retirement will last 30 years, it’s reasonable to assume average returns will be higher than their yields today. But the FPSC says its guidelines “are appropriate for making medium-term (5 to 10 years) and long-term (10+ years) financial projections.” In that context, it’s difficult to justify using 3% to 4% in a financial plan.

So how should investors adapt to lower expected returns? Too often the default decision is to tilt more towards stocks to compensate for the low yields on fixed income. That math makes sense, but the psychology doesn’t: Humans did not spontaneously become more risk-tolerant when bond yields fell below 2%. Couldn’t live with the volatility of a stock-heavy portfolio a decade ago? You certainly won’t be able to now.

When to rebalance a Couch Potato investment portfolio

Unfortunately, the solution is likely to be some combination of saving more, spending less or working longer than our parents did. We can also improve our outlook by keeping investment costs and taxes as low as possible, and by avoiding the seduction of strategies that promise market-beating returns with lower risk. No one wants to hear that, but let us be sure to remember that these factors—unlike future returns—are at least within our control.

Dan Bortolotti is contributing editor to MoneySense. Associate portfolio manager at PWL Capital (CFP, CIM)