It’s time to reset your return assumptions

There are a number of people working in the financial services industry who, in my humble and respectful opinion, are whistling past the graveyard when it comes setting return assumptions for their clients. Many in the industry continue to rely on historical returns to build out their plans. But there are many reasons why this is no longer a reasonable approach and it could be setting investors up for a great disappointment when those forecasts don’t pan out.

You don’t have to look far to see why advisors want to cling to historical returns. According to Morningstar, the returns for major indexes from 1950 to mid-2015 are as follows:

That’s a significant time frame to draw conclusions from, but investors should be reminded that returns are only part of the equation. Inflation is another important component. Over this same time horizon, inflation has averaged 3.6% in Canada.

Why your stock market returns are a lie

Understanding real returns

One of the oldest adages in financial planning is the “real returns are constant.” While not technically true in an absolute sense, the basic message is that some of the returns that people have enjoyed over the past few generations is more or less the same if you back out inflation. Whether you have an 8% return with 2% inflation or a 10% return with 4% inflation, your real return (the return after inflation) is 6%.

The real return on Canadian stocks has been 6.4% (10% nominal return minus 3.6% inflation). So with inflation at 2%, which closer to where we are today, a more reasonable nominal return expectation ought to be 8.4% going forward. But this is where things get interesting.

Setting realistic expectations

Virtually all experts believe that due to demographic trends, destitute public and private finances, middling GDP growth and other factors, there is simply no way any anyone should expect real returns in-line with historical averages. Most expect real returns to be something like 4%, or closer to 5% if you ask an optimist. And that’s the good news.

The scary news is in income markets. The current yield on a 10 year government of Canada bond is about 1.25%. The yield on a 30 year bond is about 1.75%. Assuming that same 2% inflation rate (something Canada has been extremely credible at maintaining since John Crow became Governor of the Bank of Canada in the early 1990s), that means it would take a further (and sustained) rate cut in order to simply earn a real return of zero in the bond market.

What does that mean? If we have a real return expectation of zero in bonds and say 4.5% in stocks, then we’re looking at a long-term return expectation of about 2.25% above inflation on a portfolio split evenly between stocks and bonds. Even a portfolio that is two-thirds stocks and one-third bonds should only return about 3% above inflation.

The pain in your returns

Of course, these are forecasts based on the benchmark returns without any costs factored in. The total average cost will obviously depend on which products you buy. Cheaper products such as ETFs generally cost between 5 basis points and 55 bps (a basis point is 1/100 of 1%). More expensive products such as F-Class mutual funds (those that do not pay trailing commissions) generally cost between 90 bps and 150 bps. Let’s simply use numbers that many would agree are close to the midpoint of these ranges:

Whatever benchmarks you use the expected return should be the weighted return of those benchmarks minus the cost of the products used to get exposure to them. For instance, if you had a portfolio that is two-thirds stocks and one-third bonds and you built that portfolio using ETFs exclusively, your expected return would not be a real return of 3%, but rather the 3% real return minus the 30 bps (0.3%) cost. In other words, your real return after costs here would be 2.7%.

Not-so free advice

Do you know how much you're paying for financial advice?

Here’s the thing. Many people reading this will be working with a financial advisor. That advisor might charge you something between 80 bps (accounts well into seven-digit territory) and 150 bps (smaller accounts of $100,000 or less). Once again, let’s go through the same exercise and assume an average cost that’s at the midpoint. In this case, the assumed cost of advice is 120 bps (1.2%) annually. Suddenly, those return expectations drop to a truly modest 1.5% above inflation. For those people investing thorough a bank or with an advisor, the cost of product and the cost of advice will be combined into one overall bill which is likely to exceed 2.25% and may well approach 2.5% or more. For them, the long-term real return expectation might be something like 1%.

My question to you is simple: Irrespective of whether you work with an advisor or not and irrespective of how you access to capital markets (i.e. no matter what you buy to build your portfolio) how do your expected returns compare with the mostly uncontentious assumptions set out in this article?

My personal guess is that if you’ve been following the logic that I’ve laid out above, your return expectations are likely to be a fair bit higher than what you’ll actually experience for the rest of your life. The question that this ultimately begs is: what are you going to do about it? There are four real alternatives, but that’s another column.

John J. De Goey CFP, CIM, FELLOW OF FPSC is a Portfolio Manager with Industrial Alliance Securities (iAS) and the author of The Professional Financial Advisor IV. The views expressed are not necessarily shared by iAS.