What is a reasonable expected return from your portfolio? It’s factored on a couple things: the amount of risk you are comfortable taking and the expectation of asset-class returns for the assets held in the portfolio. Consider the following scenarios where the goal is a seven per cent gross rate of return (before inflation and before fees):
In 1992, an investor could have an expected gross rate of return of seven per cent with a moderate volatility of 3.2, holding a portfolio of 56 per cent cash and 44 per cent fixed income.
By 2007, a portfolio with the same expected rate of return would have almost three times higher volatility – i.e. greater year over year variability in results and while holding a similar level of fixed income at 48 per cent and the remainder in equity investments.
Fifteen years further on, in 2022, achieving a seven per cent expected rate of return would involve a volatility of 16.8 more than five times the 1992 portfolio and would hold only four per cent fixed income and the remainder in a variety of equity investments.
Chances are many people are not necessarily comfortable with that level of volatility. The good news is, risk can be mitigated by blending a portfolio to include asset classes with lower expected volatility and by holding a broader range of assets that react to the “market” (i.e. the equity market) differently and therefore, taken together, lower the volatility of the overall portfolio.
Expected Returns for Asset Classes
To assign an expected return to each asset class, it’s useful to look at historical, average returns.
For the 15 year period 2009-2023, large-cap equities returned, as measured by the S&P 500, 14.0 per cent annually while bonds returned 2.7 per cent. A portfolio, that included large cap, small cap, international, emerging markets and various fixed income instruments, meanwhile, returned 8.1 per cent annually. And the risk, or volatility of the portfolio was 11.5 per cent versus 20.3 per cent for emerging markets equities, 21.9 per cent for small cap equities, 16,1 per cent for large cap equities and 4.5 per cent for fixed income.
However, future returns will be based on the market and economic conditions of the future and given our low-interest rate environment and increasing globalization and digitization of the economy, expectations of future returns are 6.2 per cent for the S&P 500 and 5.7 per cent for fixed income.
A simplified 40 per cent fixed income/60 per cent equity portfolio can therefore be expected to achieve a gross return of six per cent going forward.
It’s also important to know whether investors are talking about nominal or “real” returns. Real returns take inflation into account and inflation averaged 2.23 per cent over the last 20 years, according to YCharts . To provide real growth in a portfolio, it must earn enough to keep up with rising costs of goods and services plus more.
Keep Calm and Carry On
“In only two years out of the last 80-odd years have returns of the stock market and the bond market both fallen within a close approximation of their long-run average. So, returns are rarely normal, and yet most people kind of use that as their base expectation of what should I be expecting from my stock and bond portfolio,” says Don Bennyhoff, senior investment strategist at Vanguard.
To summarize, it is in fact rare that any asset class, or portfolio, achieves its average return in any given year. It can take many years before returns reflect the target. The range of returns of the S&P 500 over a two-year period can be from –39 per cent to + 47 per cent over a five-year period that range diminishes to -three per cent to +28 per cent, over a 20-year period the range of total returns closes to six per cent to 17 per cent. The longer you invest in the market and stay in the market, the better your chance of earning the average investment return.
So, when the person beside you at the next dinner party tells you their returns are 20 per cent, at the other extreme, they have “safely” tucked their money under the proverbial mattress, consider whether either of these approaches is realistic.
The 20 per cent returns likely come with extreme volatility that most investors would not be able to stomach, watching the value of their portfolios swing wildly up and down year over year. Further, most people would not be satisfied to sit in cash and watch their buying-power, and by extension the ability to maintain their lifestyle, erode.
Rather than judging whether a portfolio did “well” based on whether or not it “beat the market”, investors should consider using a targeted rate of return, based on their individualized or household tolerance for risk. If their financial plan is achievable, using that targeted rate of return, what happens in the markets on a year to year basis will be of lesser concern.
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If you have questions about wealth management strategies, you can reach me at Joelle.Hall@RichardsonWealth.com
This article is supplied by Joelle Hall of Hall Wealth Counsel, Wealth Advisor, Portfolio Manager, and Investment Advisor with Richardson Wealth.
Hall Wealth Counsel specialize in tax-efficient portfolios and planning. We help you simplify your wealth so you can do what you love with the people you care about.
The opinions expressed in this report are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson Wealth Limited or its affiliates. Assumptions, opinions and estimates constitute the author’s judgment as of the date of this material and are subject to change without notice. We do not warrant the completeness or accuracy of this material, and it should not be relied upon as such. Before acting on any recommendation, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Past performance is not indicative of future results.
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