Even the simplest financial plan requires assumptions about how your investments will perform. We know these assumptions can never be perfectly accurate, but they need to be thoughtful and reasonable. If you’re just assuming a balanced portfolio will return 7% every year, then your projections aren’t likely to be useful.
So what exactly are reasonable assumptions for stocks and bonds? In Great Expectations—a new white paper I’ve co-authored with Raymond Kerzérho, PWL Capital’s director of research—we explain the methodology we use when creating financial plans.
There are two main approaches one can use when estimating future returns. The first is to rely on history: for example, if the average return of global stocks over the last century was 8%, one could simply assume the same going forward. The second approach uses valuation metrics to estimate future stock returns based on current market conditions. You can also apply these two methods to expected bond returns, using either the long-term historical average or the current yield on a benchmark index.
As you’ve probably figured out, both methods are flawed. But as we argue in the white paper, “it is likely that when one methodology overestimates expected returns, the other will underestimate it. Therefore, using a simple average of the two methodologies may produce a more accurate estimate, as the errors tend to offset one another.”
To give an example, our long-term expected rate of return for bonds is 4.7%, while the benchmark index is currently yielding 2.6%. Most people would agree that assuming 4.7% for bonds today is overly optimistic. However, if you are making financial projections for the next 20 to 30 years, isn’t it too pessimistic to assume bond yields will never go up? The average of these two figures (3.7%) is therefore a reasonable compromise.
The other side of the coin
Investors and advisors love to talk about returns, but when the discussion turns to risk, too many are in denial. Even though the crash of 2008–09 was only a few short years ago, many seem to have forgotten that even balanced portfolios can suffer double-digit losses. A responsible financial planner needs to be sure clients understand that if they opt for 60% stocks and 40% bonds they must be prepared to suffer an annual decline in the neighbourhood of 15% and maximum drawdown of at least 23%, because these losses have happened before. Our plans therefore include the worst calendar-year losses and largest drawdowns to help investors brace themselves for what might await them.
Pulling all of the most important data together, here’s a summary of the assumptions we’re currently using with our clients’ financial plans. These numbers assume the equity allocation is split equally between Canadian, US and international stocks.
|Asset mix (Equity/bond)||Expected return||Standard deviation||Maximum annual loss||Largest drawdown|
|0% / 100%||3.7%||4.0%||–4.3%||–11%|
|10% / 90%||4.1%||3.8%||–3.1%||–10%|
|20% / 80%||4.5%||4.0%||–1.9%||–10%|
|30% / 70%||4.8%||4.7%||–4.2%||–10%|
|40% / 60%||5.1%||5.6%||–7.7%||–14%|
|50% / 50%||5.5%||6.6%||–11.3%||–18%|
|60% / 40%||5.8%||7.8%||–14.8%||–23%|
|70% / 30%||6.2%||9.0%||–18.4%||–28%|
|80% / 20%||6.5%||10.3%||–21.9%||–33%|
|90% / 10%||6.9%||11.5%||–25.5%||–39%|
|100% / 0%||7.2%||12.8%||–29.0%||–44%|
Is modern portfolio theory really dead?
One interesting thing jumps out in this table. Compare the portfolio with 20% stocks to the all-bond portfolio. The former has a higher expected return, with the same standard deviation and a lower maximum loss. That’s classic modern portfolio theory: by adding a more volatile asset class to the bond portfolio you can increase the expected return while also lowering the overall risk. With that in mind, even the most conservative investor should probably always keep 20% to 30% in stocks.
A final word about these numbers. We believe our method of calculating expected returns and volatility is useful, but they are just broad estimates. Even rounding the numbers to one decimal place probably gives an illusion of precision that doesn’t exist. It’s also important to understand that our estimates are designed to help with long-term planning. They tell you nothing about what the markets will do next year, or three years from now.
Remember that a financial plan is not a one-time activity: it’s an ongoing process that must continually adapt to changes in the financial markets, the economy and personal circumstances. Investors should review their financial plan annually and make any necessary adjustments.