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Investing decisions should always be made in the context of your overall financial plan. And although we know short-term forecasts are futile , a retirement plan needs to include some assumptions about returns and risk over the long term. To help with this important task, my colleague Raymond Kerzérho , PWL Capital ‘s director of research, has just updated our white paper, Great Expectations: How to estimate future stock and bond returns when creating a financial plan . As we explain in the paper, there are two main approaches to estimating future stock returns. The first is to rely on a historical premium: over the last 50 years, stocks have delivered returns of about 5% above inflation, so one could simply expect that to continue. The second approach raises or lowers that expected premium depending on whether stocks are currently undervalued or overvalued. You can apply similar methods to expected bond returns, using either the long-term premium (about 2.7% over inflation) or the current yield on a benchmark index. Both methods are flawed, but an average of the two is likely to be a useful estimate. Imagine that you are doing retirement projections going out 30 years. Using an expected return of 4.5% for bonds based on their long-term average seems wildly optimistic. But on the other hand, assuming bonds will yield just 2% for the next 30 years (based on their yield today) seems unnecessarily conservative. An average of these two estimates (3.3%) is a reasonable compromise. You can dig into the paper for all the details, but here are the numbers we’re using for inflation, bonds and stocks in our plans these days: Estimated long-term returns (as of December 2015) Asset class Expected return Inflation 1.80% Canadian bonds 3.30% Canadian equities 7.10% U.S. equities 6.30% International developed equities 7.20% Emerging markets equities 9.80% Source: PWL Capital And here’s how those numbers combine in various balanced portfolios. In the table below, we’ve also included the standard deviation (a measure of volatility) for each asset mix, and the maximum drawdown (or cumulative decline) experienced in similar portfolios since 1988: Expected return and risk of various portfolios Equities/Bonds Expected Return Standard Deviation Cumulative Decline 0% / 100% 3.30% 3.90% -11% 10% / 90% 3.60% 3.80% -10% 20% / 80% 4.00% 4.00% -10% 30% / 70% 4.40% 4.50% -10% 40% / 60% 4.80% 5.30% -14% 50% / 50% 5.10% 6.20% -18% 60% / 40% 5.50% 7.20% -23% 70% / 30% 5.90% 8.20% -28% 80% / 20% 6.30% 9.20% -33% 90% / 10% 6.70% 10.30% -39% 100% / 0% 7.00% 11.40% -44% Sources: PWL Capital, Morningstar Direct How low can you go? In this new edition of our paper (which was first published almost two years ago), we’ve added a postscript to help put these numbers in context. If you’ve looked at the returns of a balanced portfolio over the long term , you may be surprised (and disappointed) by the expectations we describe in the paper. Even since the late 1980s, traditional index portfolios delivered annualized returns in excess of 7% or 8%, even with a conservative asset mix, compared with our expectation of just 5.1% for a portfolio of half stocks and half bonds. Why so gloomy? The first important point is that over the last 20 to 30 years, bonds enjoyed a long bull market as interest rates trended steadily downward (10-year Government of Canada bonds yielded close to 10% in 1988). This cannot be expected going forward, so we think it’s reasonable to plan for conservative portfolios to deliver significantly lower returns in the foreseeable future. It’s also reasonable to expect equity returns to be lower than they have been since 1988. By traditional valuation measures, stocks are relatively more expensive today: for example, the S&P 500 had a price-to-earnings ratio of 14 at the beginning of 1988, compared with 24 at the end of 2015. Finally, inflation was 4% in 1988, compared with just 1.4% in 2015. The numbers in the tables above are nominal returns, which are not adjusted for inflation. Remember that a 6% return with 2% inflation is very similar to an 8% return with 4% inflation. When viewed in terms of purchasing power, the gap between historical returns and expected future returns is not as wide as it first appears. Disclosure: Holdings include: ZRE, HXT, XRB, XMD, VAB, VTI, VXUS. Scalper1 News
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