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.
I am 100% in the stock market and seeing that I can loose 44% makes me think if I should consider bonds, especially after last few years were so good on stocks…
Another great post!
Quick question: Are the expected returns shown “real” (after inflation) or “nominal” (before inflation)?
Thanks.
RE: DaveL
I’m certain they’re nominal returns.
RE: CCP
What are “bonds” in your table? Universe?
@DaveL: They are nominal returns. The paper explains that we then assume 2% inflation.
@Malnar: The full methodology is explained in the paper itself. For bonds we used the Bank of America Merrill Lynch Canada Broad Market Index, which is similar to the DEX Universe.
@VM: I like to remember Warren Buffett’s comment that anyone invested in stocks must be prepared to lose half their money. This applies to all equity investors, no matter how well diversified they are. It’s amazing how short our memories are. The last 50% decline was barely five years ago and there is always the possibility it will happen again.
CCP: Thanks for the prompt response.
The confusion of “real” returns versus “nominal” returns has always been a pet peeve of mine with almost all investment documentation, especially when dealing with long term bonds and inflation. I’d suggest it’s time for a special symbol (or convention) to clearly indicate the type of % return being discussed (for example %R and %N – with R/N subscripted).
I’m assuming costs still need to be taken account when planning. Assuming 1% cost for a 100% bond portfolio (Mawer Canadain Bond fund has a .85% MER) and inflation of 2%, that would give an expected return of 3.7%n – 2% -1% = 0.7%r.
Then, we can’t forget the tax man. Take another .3% to .5% off for that, leaving (0.4%r to 0.2%r).
Yikes, that really stinks considering there is still some very real risk involved.
“The last 50% decline was barely five years ago and there is always the possibility it will happen again.”
I would argue it’s a certainty it will occur again. ;)
Looking forward to reading the white paper and understanding the methodology for the annual loss and drawdown numbers.
@gsp: You might be surprised how many people are in denial about a 40% to 50% decline. We regularly hear people say 2008 was a once-in-a-lifetime event that will never happen again. I hope that’s true, but I wouldn’t bank on it!
@CCP:
After 2% inflation, the expected return of the 40%bond/60% equity portfolio is only 3.1%…is this enough for young investors without any defined benefit pension plan?
@Jas: I guess that depends how much people save. You raise an important issue: too often I hear people say that expected returns are low, so they need to take more risk. But if you’re not comfortable with volatility (and very few people are!) then that’s not really an option. You will likely blow up your investment plan the first time you experience a bear market. Saving more, working longer or making do with the less are the only alternatives:
https://canadiancouchpotato.com/2013/01/21/does-a-6040-portfolio-still-make-sense/
@DaveL
Why limit yourself to bond-only portfolio when adding just 20% stocks bumps up expected return (+0.8%) without increasing risk?
Also, why Mawer fund? Have you seen CPP’s model portfolios? VAB’s MER is 0.23% (0.62% less than Mawer!).
Just these 2 things add 1.42% to real return of the portfolio.
We invest to spend in the future, so estimating real returns are the only relevant way to estimate future purchasing power. Any discussion of financial planning should only use real returns to make this point crystal clear. It is unfortunate that the table in the post uses nominal returns without any indication of the assumed inflation rate (yes, I realize the paper mentions all that, but not everyone who reads this post will read the paper).
For that matter, past investment results should always be calculated as real returns as well for the same reason.
Great video to understand portfolio return rate and its relation to risks.
https://www.youtube.com/watch?v=efPKwxZuLKY
Take a note that 100% bonds portfolio is proven nonsense (same as shown above in the article).
@IG:
Thanks for your comments.
My intent was not to suggest anyone actually create a 100% portfolio using a “low cost” mutual fund (Mawer tends to be low cost relative to their peers). I was trying to illustrate what dismal after tax “real” returns are available if one “blindly” goes with a “super safe” bond only portfolio (not withstanding that, as you noted, adding 20% stocks would be “more safe”).
I didn’t look in detail at the bond investments in the model portfolios, thanks for pointing that out. .23% wow!
@Steve
I totally agree with your post. Even though the (very well written) paper does discuss the issue of inflation, some its tables are labelled simply “expected return” with % values (you would have to hunt around a bit to be sure you are looking at nominal or real returns).
In my perfect world the “units” would (where possible) add much needed clarity. That is, instead of $ we would see CA$ or US$, MPG would be MPGus or MPGimp (miles per imperial gallon), % (when talking returns) would be %r or %n etc.
I would add that, ideally, discussions of financial planning also remind the reader whether or not the indicated returns are net of costs or not (as CCP usually does).
Thanks to all.
@DaveL:
“Even though the (very well written) paper does discuss the issue of inflation, some its tables are labelled simply “expected return” with % values”
The 2 tables in the concluding section of the paper “Putting it all together” – “Expected return and risk of various portfolios” on page 7, and “Expected risk of loss for various portfolios” on page 8 – are purely in nominal return terms with no mention of inflation at all.
This is a failure of presentation in the paper IMO, as it tends to downplay the fact that real returns and losses actually experienced by an investor will be worse than the nominal expected returns and losses listed – which are largely meaningless for planning (except for calculating expected tax liabilities).
Assuming we don’t fall into long term deflation, of course!
This is fantastic. I generally refer people to this page, and add a ton of explanation: http://www.finiki.org/wiki/Portfolio_design_and_construction#Asset_allocation. Now I’ll refer them to this post with significantly less explanation required. :)
@Steve: I appreciate that some people prefer to work with real returns, but it’s too much to say that nominal expected returns are “largely meaningless for planning.” When we prepare plans, we use nominal dollars for income and expenses and increase them based on 2% annual inflation. Most people find this easier to relate to their lives. For example, if you’re saving for a future goal you can see how much you will actually need rather than seeing that amount expressed in 2014 purchasing power. As long as all the cash flow projections increase with inflation, nominal returns make tracking your progress easier because they don’t anchor on the first year of the plan.
That said, we have had a small number of clients who prefer to think in real terms, and it’s easy enough to adjust the software accordingly.
@ CCP:
Yes, when you put it that way I did somewhat overstate the case. My concern was with the tendency by individual investors to ignore inflation – not much of a problem in calculating ROI year over year currently! – but a potentially serious issue when using unadjusted expected returns in planning scenarios over decades. This would not be a concern for your clients, of course, but (based inter alia on the comments sections of your posts) not accounting for inflation would seem to be a real issue for many DIY investors. Thus my wish that your post (and the paper it drew from) had been much more explicit about citing nominal expected returns and consequently the need to further account for inflation.
“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.”
@CCP: I want to understand exactly what you are conveying by this. The True Couch Potato doesn’t profess to have special knowledge of the future, so he constructs a strategy consistent with his life circumstances and risk level that is resilient enough to to tolerate a wide variety of future unknowns; he resists tweaking yearly according to supposed tactical factors, but alters his asset allocation on a long term strategic basis as his life cycle (investment horizon) evolves. But these changes are anticipated long in advance.
Apart from unexpected changes in personal circumstances (which could reasonably trigger changes in long-term strategy) what sort of changes in the economy or financial markets encountered during the annual review would you see as a reasonable trigger for a change in our Couch Potato strategy, given that we’re not supposed to believe in tactical factors?
To try and answer my own question, I suppose an unexpectedly high return in equities that boosts one’s total portfolio net worth to a previously unanticipated high value might reasonably be dealt with by a change in asset allocation to a lower risk model that will assure funding of one’s retirement with less risk (even if one’s professed risk tolerance was higher than that). Is this the sort of thing you meant? I can’t think of any other “for instances” right now.
@VM – You won’t ‘lose’. You will have a dip that will eventually return to the previous valuation. You’ll only lose if you sell.
@Noel: I don’t think you have given an adequate explanation to @VM, given that VM may be a complete neophyte to the concept of Passive Index Investing. At bare minimum, I think one should add some cautionary phrase like “…that will eventually return to the previous valuation, assuming you have the confidence and patience to wait long enough, a period which in the last century of tracking North American returns has lasted as long as fifteen years (nominal returns), but might conceivably take longer in the uncertain future.” But even this bare bones explanation runs the risk of being incompletely understood, and omits the note that there are less risky investment strategies than 100% equites.
@Noel:
“@VM – You won’t ‘lose’. You will have a dip that will eventually return to the previous valuation. You’ll only lose if you sell.”
If the market is down you have a loss – it makes no difference to that fact whether you choose to realize that loss by selling, or not.
Selling on a market drop is not discouraged because it notionally “creates” losses, but because it is irrational: if an index was worth holding pre-loss, then it should be even better “value” (i.e., have a higher expected return) starting from its new, lower valuation.
(In fact, from a tax perspective, a substantial market loss creates a valuable asset, in the form of a realizable capital loss that can be “harvested” to offset other gains and thus save taxes – with the sale proceeds then reinvested in a similar index to maintain one’s asset allocation, of course!)
Needless to say, there are no guarantees an investor will ever earn that new higher expected return.
My biggest issue is inflation. I lived in the country that had to go through hyper-inflation and saw what it does to people. It was devastating to see close to me people losing all savings. I saw people go from very wealthy retirees to living on just social benefits. Because of that 100% of my investments are in equity. I am afraid that if I’ll hold bonds, GIC and hyper inflation will hit Canada (or USA), I will loose that money. I believe that stocks will somewhat follow dollar value. So after some thought I decided that I’ll stay 100% in stocks.
If anyone can suggest better options for anti-inflation investments – I would be very interesting. Previously I thought that gold stocks would help with that, but as you probably guessed, over last year I lost lots of money on XGD.TO. So no, gold is not something that helps with my hyper inflation fear. Real estate REITs also have their own cycle and not a “safe” investment.
@PS:
Nothing is guaranteed, but the surest inflation hedging investment around is probably Government of Canada Real Return Bonds (RRBs).
Unfortunately the benchmark RRB, maturing in 2041, currently has a “real” (inflation-adjusted) yield of only about 0.85% as of last week:
http://www.bankofcanada.ca/rates/interest-rates/canadian-bonds/
(scroll to the bottom of the page)
No one can know what would happen to RRBs in the event Canada experienced Argentina-style hyperinflation – but if that is a major concern perhaps financial markets are not the best solution in any case, since they may not continue to function normally in such a scenario.
Perhaps I missed it but I did not see the reference period for the maximum annual loss or largest drawdown disclosed in the white paper.
With most Canadians having most if not all of there net worth in one asset (housing) and next to nothing in there savings plan for retirement, it is concerning to me when I sit down and see that going forward the only real option with no significant savings is the stock market with lots of stocks and with a forecast of maybe 7% on a good day over the long haul, this is going to be one rough ride, fasten your seat belts, those returns suck!!
Great article once again Dan! I think the people complaining about real/notional returns just didn’t bother to read the white paper that explains things clearly imo. Also I always expect that returns are expressed as notional returns unless stated otherwise (ie if someone says their return is 5.4% I assume that’s pre-inflation). It takes quite a leap to interpret the charts in the article as inflation-adjusted. Anyway I think your articles are of such high quality that you get held to a higher standard in the comments.
I will say this information about estimating returns is very hard to find, and I really appreciate the open, transparent and reasonable methodology you’ve come up with. Great work!
I’m sure you’re familiar with the Smith Manoeuver, a leveraging strategy that I expect you will find incompatible with the couch potato philosophy. However, given the expected returns from an 80/20 stock/bond portfolio and current HELOC rates it seems to me that with a long time horizon and the stomach to handle volatility I could stand to benefit from using an investment loan couch-potato-style.
However I wonder about using the Smith Manoeuver to buy bonds (or any fixed income instruments) – usually before I would start leveraging (ie increasing risk) I would first increase my risk profile by reducing my fixed income component, and I would not begin leveraging (taking on additional risk) until my fixed income was down to 0%. But given the tables above, it seems as though I would stand to benefit from an 80/20 approach even while under leverage. How can this be?
Any thoughts on this issue would be greatly appreciated. Thanks again!
@DanD: Thanks for the comment, and glad you liked the paper.
I appreciate that some people have used leverage successfully, but it’s not a strategy I would recommend unless an investor has a proven record of being able to handle volatility. Many investors who now say they are comfortable with 100% stocks have only had that allocation for the last five years, one of the great bull markets in history. There hasn’t been much volatility (with a little interruption in 2011). If you were 100% equities in 2008–09 and didn’t abandon your plan, then I’d say you can handle it. Even then, try to imagine watching your portfolio decline by 50% while also holding a large loan on a house that probably also fell in value (at least temporarily) while your job may have been in jeopardy.
As for the 80/20 mix, leveraging doesn’t change the volatility of a portfolio’s asset mix. Maybe the disconnect is that you’re thinking of your loan and a bond as two sides of the same coin (i.e. you’re both borrowing and lending), but that’s misleading. If stocks were to tank, the value of the bonds in the portfolio would likely go up and offset some of that. The interest rate on your HELOC might even go down, which is what happened i 2008-09.
@gsp: Sorry for the delay in responding: I had to check with my colleague, Ray Kerzerho. The maximum loss and drawdown data go back to 1988, as that is the earliest date for emerging markets data. Even for Canadian bonds the data only go back to 1980. Good quality data older than that would have to be confined to the US.
@CCP: If income tax were taken into consideration, would only the “expected returns” column be affected or can the tax (directly or indirectly) affect the other columns as well? Thanks for the great articles, keep them coming.
Thanks CCP, that confirms what I suspected. The numbers all appeared a bit rosy to me when I first saw them. ISTM we ought to be careful basing worst case scenarios on only 26 years of market data.
The U.S. data looks very different over the last century rather than just the last quarter century and that’s an extreme case of positive selection bias. Many a stock market did not survive.
My guess is the folks at Credit Suisse who publish the excellent annual Global Investment Returns Yearbook would have the data necessary to simulate a much lengthier period even if some concessions might have to be made(EM).
Great article, CCP. One thing that always strikes me with these sorts of projections is how much additional risk an investor assumes for a potentially modest bump in total returns. A conservative 30/70 portfolio is projected to make 4.8% while a more aggressive 70/30 projects to 6.2%. That 1.4% difference is of course significant to total returns, but not to the extent one would expect depending on the years remaining until retirement. I have about 15 years to go and in that relatively short time period the extra 1.4% doesn’t necessarily seem like it’s worth the additional downside risk one must assume (not to mention loss of sleep). Again, in no way suggesting everyone should be that conservative. My observation is only that, depending on the investor and their portfolio horizon, the difference in returns isn’t SO great that some investors wouldn’t be better served by assuming less risk in their portfolio, and instead focusing on saving more or finding ways to reduce the amount of money they expect to spend in retirement.
Good post Juan. For those behind the curve with no savings, divorce, etc or just not saving and there are lots of us, there is no other way. You have less or nothing at retirement or you go with a all stock portfolio. Never tried alpo and don’t think I want to so I will roll the dice with 13 years to 65 and go with all stocks.
With bonds paying about Zero after fees and inflation, I see no sense in this if your behind the curve. The real risk for people behind the curve is running out of money.
@ mark: No, No, No! I think you miss the point.
“For those behind the curve..there is no other way”. You cannot make risk go away. It is still there even if you don’t look at it.
“I will roll the dice with 13 years to 65 and go with all stocks.” All stocks? Really?
“The real risk for people behind the curve is running out of money.” I would say the real risk for people behind the curve, and taking irrational risk (irrational in the sense that they have reasoned that there is really no other choice, and that this is a reasonable risk, when really in their soberest moments they would have to admit that their risk tolerance — how they would accept losses when the equity values have declined 50%, say — hasn’t changed, and is really quite low) is living like they’re going to win their bets and then losing 50% of their money. Or worse, I guess, losing 50% despite “strategic/tactical” selling. Read more of this website.
@mark: and even if you want a huge tilt to equities, which I don’t necessarily agree with in your situation, you miss the other point that although bond returns seem low when viewed in isolation, adding even 20% bonds to your equity dominated portfolio would add a huge (disproportionately so, despite being only 20%) measure of safety to it, while paradoxically losing a very small (if any) amount of total projected returns, due to the magic of Asset Allocation and general non-correlation.
The magic works in the other direction, too, with 20% equity 80% bonds being LESS risky than 100% bonds, but under the circumstances, that’s unlikely to be attractive to you
I swear this is the smartest Canadian (or maybe even international) finance web site on the whole Internet. Everything is always presented so clean, logically, and well-researched. I highly doubt there’s any possibilty of me finding a local advisor smarter than Dan and his CCP cohorts. …And I don’t need one given the volume of comprehensive information here. Well, at least not until I hit the $500K mark or something, then I may need to go looking. I hate to build egos, but thanks again, D!
@Edward: Many thanks for the kind words, and glad you’re enjoying the site!
Personally, I take the conservative number to give ourselves some error space. I think the real return of 3.5% for 50/50 is at the high end. Using the Shiller’s CAPE approach, 2.5 – 3% (real) is the number for me.
Please advise definition of “largest drawdown”. tks
@Dave: The largest drawdown is the greatest decline from peak to trough over any period. For example, the S&P 500 fell about 50% from its high in 2007 to the market bottom on March 2009.
Hi CCP, I found the article very interesting and useful. But, I have to admit I found the rates of returns a little depressing. Particularly because long term ROR that I have seen in the past have been higher. Can you please clarify the way you arrive at the ECOC premimums above inflation? In the paper it says “This is an estimate for the 50-year return of an asset class based on history…” As mentioned I thought the ROR would have been higher so I did some digging on the US ones because data is easy to find. In your table the ECOC Expected Premium Above Inflation is 5% for U.S. Equities. I found the following annualized inflation adjusted returns for the S&P 500 (for periods ending Dec. 2013):
50yrs=5.9%
100yrs=6.5%
142yrs=6.9%
The data above for the S&P500 is 0.9-1.9% higher than the value in your table. I am just surprised (plesently) at the discrepency. Can you elaborate?
@Geoff: US stock returns have been among the highest in the world over the last century or more. It’s unrealistic to take a best-case scenario and assume it will be the case across all markets in the future. The Credit Suisse Global Investment Returns Yearbook includes data from 23 countries since 1900 and gives the real return on stocks as 5.2% during this period. See page 61:
https://publications.credit-suisse.com/tasks/render/file/?fileID=0E0A3525-EA60-2750-71CE20B5D14A7818
The Yearbook also notes on page 60: “There is an obvious danger of placing too much reliance on the excellent long-run past performance of US stocks… In just a little over 200 years, the USA has gone from zero to almost a one-half share of the world’s equity markets… Extrapolating from such a successful market can lead to ‘success’ bias. Investors can gain a misleading view of equity returns elsewhere, or of future equity returns for the USA itself.”
Hi CPP, thanks for the clarification.
Hi CPP, trying to wrap my head around these numbers. There is a disconnect between the low dividend yields i am seeing in index etfs and the cumulative returns over time. Say, dividend yield of 1.5% a.nd a share costs $32, 100 units would net you (32*0.015)*100=48 bucks. 100 shares is also worth 3200, and $48 is kind of a measly return if inflation is 2%.
Am i missing something?
@Art: The dividend yield is only one portion of the total return: with equities one would also expect price appreciation over time. If one expects a 7% return on stocks it might be a 4.5% capital gain and 2.5% dividends (I’m just making these numbers up for illustrative purposes). The same is not true for bond ETFs, however. The yield to maturity is a reasonable estimate of the total return.