My father was fond of remarking that a man who has low expectations can never be disappointed. I prefer to think that he did not mean this remark as a reflection upon his experience as a parent, but rather as an investing tip.
It's a tip that has special relevance these days, with interest rates scraping along historic bottoms and stocks hovering at scary heights. Given this ugly starting point, how much can an investor reasonably expect to earn in the years ahead?
A survey last year by Natixis Global Asset Management found that Canadians think it's reasonable to assume returns of 9.3 per cent a year above inflation – call it a tad over 11 per cent with inflation added in.
The problem is that this number is unusually high by historical standards. Given current conditions, it seems wildly unrealistic. A more sensible return target for the years ahead may be 5 per cent, inflation included, and even that will take some doing, according to folks who should know.
Investors will have to be nimble to thrive in an era of 5-per-cent returns. But before we discuss how, it's important to understand why you may want to keep your expectations in check.
It starts with low bond yields. A bond's yield – what it's paying out to investors as a percentage of the bond's current price – is a fairly accurate indicator of the return you can expect to earn from it. Unfortunately for investors, bond yields – and therefore probable future returns – have fallen to dismal levels in recent years.
Based on current yields, investors are unlikely to harvest much more than a 2-per-cent return from their bond portfolios over the coming decade, according to a report from ReSolve Asset Management in Toronto.
Stocks look better, but are nowhere close to being bargains. Measured in terms of underlying sales, or historical earnings, they are very expensive.
There are many ways to estimate their future returns, but one technique used by ReSolve is to assume that stock returns will beat 10-year bond returns by the same margin they have in the past. If so, stocks are likely to earn returns of around 5 per cent a year over the next decade.
Many investors are not prepared for quite how low these numbers are. Given a standard portfolio mix, most people's retirement savings seem likely to generate annual returns of a measly 4 per cent or so – and don't forget, that's including inflation but before fees and taxes.
Depressing, isn't it? Unfortunately, it's hard to refute the logic. Many experts agree we are entering an era of low returns.
GMO, a widely followed money manager in Boston, says many U.S. and international assets will lose value over the next seven years.
In Canada, the Financial Planning Standards Council says planners should assume a typical balanced portfolio of stocks and bonds will return only 5.19 per cent a year before fees. That, of course, is about half of what most people seem to be expecting, based on the Natixis poll.
The obvious implication is that people will have to save more – perhaps much more – to meet their goals. They may also have to become more adventurous to reap a decent return.
An ingenious – and free – new tool can help you experiment with alternative plans. Offered by Research Affiliates LLC, a prominent California-based investment shop, it lets you mix your own blend of assets, then see how that portfolio is likely to perform over the decade ahead, according to the company's rigorously quantitative model.
Like me, you may be surprised at how difficult it is to find any relatively safe combination that yields much more than 5 per cent, especially in after-inflation terms. Also surprising is how the most attractive returns nearly all come from emerging markets and other exotic locales.
To be sure, these are just projections and may prove to be wrong. But they remind us that investors should be willing to look beyond North America for promising investments.
Fundamentally, the model's results also underline the strong case for modest expectations in an era where 5-per-cent returns seem likely to be the norm. As my father would have told you, a pessimist's portfolio may not be perfect, but at least it's immune to disappointment.