You can’t make your badass financial plan without first having some idea of what kinds of long-term returns you will get on your investments. So, for the stock & bond portion of your investment portfolio, that’s what I’m going to give you in this article.
Why This is Important
(BTW, feel free to skip this section if you don’t really care about the rationale – it’s not critical and a little heavy).
The fact of the matter is that the estimates of returns help us to make educated decisions concerning our financial future. Here’s an example of how:
Determining Asset Allocation Based on Risk
The risk-return theory asserts that, for the opportunity to achieve higher returns, you have to take on more risk. As a general rule, stocks return more than bonds over the long-term but they tend to be more volatile (i.e., stocks’ values fluctuate more wildly over the short-term than do bonds’ values). Put another way, the greater the ratio of stocks to bonds in your portfolio, the higher the expected returns and the higher the risk of short-term losses. It can be pretty difficult to predict short-term returns but we’re not really all that interested in those anyway (See my article on speculating vs. investing for more on this). What we care about is our retirement nest egg (i.e., the long-term). So, if we know how big of a nest egg we need (we’ll go through this in another article) and how much we have right now (as well as how much more we’re going to be able to contribute to it between now and retirement), then we can figure out what rate of return we’re going to need so that we can retire when we want to. One thing I should mention right now, though, is that if your time horizon before you’ll need to start using your nest egg is really long (i.e., a few decades or so), this doesn’t apply so much. As long as you can stomach the market volatility, I’d suggest you put the vast majority of your money into stocks as bonds are likely to just drag down your returns. Where this asset allocation strategy comes into play more is when you’re getting closer to retirement but still require more growth from your nest egg before you’ll be ready financially. Having some idea of rates of return allows you to structure your portfolio with only the necessary proportion of stocks (but no more). This lowers the risk and the volatility of your portfolio in the home stretch.
This helps us to determine the proportion of stocks versus bonds we’ll need to maintain to get there.
Knowing what kinds of returns you’re likely to get with a particular ratio enables you keep your bond percentage as high as possible (thereby lowering your short-term risk) while still achieving the desired outcome.
No, this isn’t where I pull out my crystal ball. (I’m currently using that to try to predict the next round of cuts Ontario MDs are likely to suffer from Kathleen Wynne et al.)
Fortunately for us, we have a myriad of data at our collective fingertips that can help us to come up with a workable (albeit limited) glimpse of the future. Even more fortunately for me, Raymond Kerzerho and Dan Bortolotti of PWL Capital Inc. published a fantastic white paper in March, 2016 entitled, “Great Expectations – How to Estimate Future Stock and Bond Returns When Creating a Financial Plan” that explains it all very nicely.
I’ll give you the highlights here.
Below is a table with predictions of returns by asset class. But first, a few points to help you understand it better:
- Nominal Returns don’t take into account inflation, which definitely matters but for some reason isn’t often factored in when you hear someone quote a particular number for Return on Investment.
- Real Returns, on the other hand, are the Nominal Returns minus inflation, which has usually been between 2-3% per year in Canada. In 1991, the Bank of Canada set the inflation control target at 2% and has been maintaining inflation at roughly that number – 1.8% on average – ever since. So, for the sake of our calculations, we’ll use 1.8% for the difference between Nominal and Real Returns.
- You’ll note that in columns 2-5, there are “Conservative” and “Optimistic” figures. The reason for this is that there are many different methods of forecasting returns based on such things as current market conditions, historical performance, etc. The actual number that we’ll end up seeing will likely fall somewhere in between the two.
- “PWL’s Forecast” is Raymond & Dan’s best guess of what the actual returns will be (they really just averaged the “Optimistic” & the “Conservative” values). These last two columns are the ones we’ll use for our example, below.
Let’s say you invest $100,000 today as follows: (e.g., the Canadian Couch Potato “Aggressive” allocation)
$10,000 the BMO Aggregate Bond Index ETF – ZAG (Canadian Bonds)
$30,000 of the Vanguard FTSE Canada All Cap Index ETF – VCN (Canadian Equities)
$60,000 of the iShares Core MSCI All Country World ex Canada Index ETF – XAW (International Developed Equities)
For the sake of this example, let’s assume we’re investing in a tax-sheltered account (taking taxes out of the equation for now) and that we’re taking a DIY approach to investing using a discount broker that doesn’t charge fees for purchasing the above investments (and the small annual management costs are negligible paid for out of your pocket with other money). If we let these investments sit untouched for 30 years, a decent estimate of what we’re likely to end up with can be calculated as follows (you can use my Investment Compounding Calculator):
$10,000 at 3.3%/year for 30 years = $26,485.59
$30,000 at 7.1%/year x 30 years = $234,858.01
$60,000 at 7.2%/year x 30 years = $483,053.03
Which equals: $744,396.63
Remember that these are predictions of Nominal Returns (without factoring in inflation). These are not really the numbers that we care about, though. Our driving purpose when investing is to give ourselves future purchasing power. Thanks to inflation, what $100 buys us today is more than what it will buy us tomorrow. Properly quantifying future purchasing power involves using inflation to turn today’s dollars into tomorrow’s.
As it turns out, in 30 years (assuming average annual inflation of 1.8%), $744,000 would only buy us the equivalent of what about $436,000 would buy us today. So, as you can see, inflation really does matter.
NB: The other major parts of the puzzle of predicting Return on Investment are the impacts of taxes and investment fees. These vary from investor to investor based on whether their investments are in a tax-sheltered account (and, if not, what their income tax bracket is) and whether they pay someone to do their investing for them or they choose the lower cost DIY route. A Canadian MD who’s a true financial badass will capitalize on both of these options.
Caveat Emptor: While all of these factors are vitally important for Canadian MDs to take into account when implementing our plans for a badass financial future, they are, at best, just educated guesses (and many things, including annual rebalancing, are likely to throw things off significantly at times) so please incorporate a healthy factor of safety when doing your own planning – I’d strongly suggest getting a pro to help you with this.
Action Steps (20 minutes)
- Make a list of your investments and their current market values.
- Head over to my Investment Compounding Calculator and input the variables from the table above to get an idea of what a future value of each will be depending on its asset class and your time horizon (note that the calculator also allows you to factor in regular additional contributions you’re likely to make along the way – if you’re going to get all fancy and do this, remember to only factor in the proportion of that annual contribution that you’ll devote to each asset class annually; e.g., taking the above example and adding $10,000 annually, you’d include $1,000 in the ZAG calculation, $3,000 in the VCN calculation, and $6,000 in the XAW calculation).
- Total these to get the estimated future (Nominal) value of your portfolio. Is this in line with your previous estimation of what you’ll need to retire?
- Using inflation of somewhere around 2%, convert this Nominal value into today’s dollars to give you a better idea of what it really means in terms of purchasing power. Does this fit with your retirement goals?
What do you think about the Return on Investment predictions for a Canadian MDs’ stock & bond portfolio?
Please add your two cents below.
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