Guidelines for Projecting Investment Returns
Ten percent per year! That’s a nice round number and what many investors think is a realistic annual investment return. At that rate, following the “Rule of 72,” you will double your account value in 7.2 years – without adding an extra dollar!
Let’s imagine that you are 40 years old. You hope to retire at age 65. According to a study published on ratehub.ca, you will have about $104,159 in savings set aside in RRSPs, TFSAs, and non-registered accounts. If you decide not to save any more money, by age 65, this rule suggests you should have over $1 million. Fantastic! But is this a realistic projection?
I will argue that doubling your assets every 7.2 years is an unlikely prospect. First, markets are simply not that consistent. Second, real life in investing just doesn’t work that way. Even if some markets, perhaps the U.S. equity market to name the most prominent example, may average 10% per year, or more, the average investor’s experience does not match that return. First, there are the frictional costs involved: bid-ask spreads, commissions, and fees, to name three. Second, we experience our investment returns in sequence, not as an average.
Let me illustrate:
You invest in the stock market. In Year 1, you earn a 50% gain. In Year 2, however, you experience a 50% loss. Averaging a 50% gain followed by a 50% loss works out to an average return of zero. It’s as though you held $100,000 in a chequing account that paid no interest and did nothing with it. At the end of two years, you would still have $100,000.
Now, let’s look at this situation in something closer to real life. You have $100,000. You invest it in the stock market on January 2 and have a fantastic year. Your $100,000 gains 50% by December 31 of that year and is now worth $150,000. However, in the following year, you lose 50%. Fifty percent of $150,000 is $75,000. On December 31 of the second year, you only have $75,000 left, which is $25,000 less than what you started with. That works out to an annual loss over two years of 13.4%.
Losses mess with returns over time. In Scenario 1, I set up a 21-year period of investing $100,000 in which an investment return of 20% in the first year was followed by a loss of 19% in the second year. In the third and fourth years, the gain was 18% while the loss was 17%, respectively. And so on. The average return was 0.571%, and yet the value of the account at the end of the 21 years was $97,641. I took that average return and in Scenario 2, I set up 21 consecutive years of returns of 0.571%. The result was a final value of $112,071.
If you want to find out more about this as it relates to investing, look up something called “geometric mean” returns.
Enter FP Canada
What are suitable numbers to use for investment returns? FP Canada, the body that offers the QAFP™ and CFP® financial planning credentials, has for the last several years provided a document known as the Projection Assumption Guidelines. The annual guidelines go public on April 30 each year. These guidelines are a helpful reminder that financial planners must use projections that have a reasonable foundation to them. That foundation should not be as simple as “The Canadian stock market returned 25% last year. We think it will do the same this year.”
Sources for the Projection Assumptions
As that famous philosopher, Yogi Berra was once reputed to have said, “It’s tough to make predictions, especially about the future.” To limit individual bias, and provide projections that are useful beyond a decade, the authors of the guidelines work as a team and draw on many diverse sources of information, such as actuarial reports from the Canada and Quebec Pension Plans, surveys from investment professionals, and a historical average of returns over the last 50 years. And then, in recognition of the variability of long-term returns, the authors reduce the results by 0.50%.
When a group of circumspect analysts and planners get together, their projects are bound to be less enthusiastic than the latest TikTok influencer. Instead of doubling your many every year, you may want to temper your expectations.
The categories may benefit from a bit of explanation.
This category is based on the projected returns for 91-day Treasury bills. The closest equivalent might be a Money Market mutual fund. Having said that, many of the online or discount brokerages offer investment savings accounts (ISA) that are bought and sold like mutual funds but are treated as deposit products and thus have the protection of the Canada Deposit Insurance Corporation (CDIC). Many of these ISAs currently have rates greater than 4%, which may make them particularly attractive now. But, from the long-term perspective, those rates are almost certain to moderate.
If you held a broad-based Canadian bond fund, or an index-tracking Exchange-Traded Fund (ETF) with the word Universe or Aggregate in the fund name, this would be your closest equivalent. Bonds had a particularly bad year in 2022, reducing their prices substantially. This has had the effect of increasing yields and putting many bonds that were issued before last year in a discount position. This means that the bonds are likely to return value not just from interest payments but also from capital gains, which makes bonds attractive even in a non-registered account.
The most well-known Canadian stock index is the S&P/TSX Composite. Again, if you were to find an equivalent among the universe of available investment products, most index-based Canadian equity mutual funds or ETFs would fit this category, although most funds use a “capped” version that limits the weight that any one security can hold in the index.
Foreign Developed Market Equities
This is not a category seen that often and I sometimes wonder why FP Canada does this. There are two more common categories covered here. The first covers International Developed Markets outside of North America, such as the markets of Europe, Australia, and Japan, to name a few. This can be represented by any fund that uses the MSCI EAFE (Europe, Australasia, and Far East) index as a benchmark. The second is the US market as represented by the S&P 500. Each index is weighted at 50%, even though the US is close to 60% of the entire world’s stock market capitalization, while the EAFE index covers closer to 28% of the world’s stocks. Having said that, I don’t know whether you would want to make a dramatic change to how much you should expect in returns from a fund that tracks the S&P 500 versus another fund that tracks the MSCI EAFE index. Interestingly, for the year ending April 28, the EAFE index is up almost 10% from the S&P 500, which is a change from the world-beating performance of U.S. stocks for most years of the last decade.
Emerging Market Equities
This last category covers approximately 10% or so of the world’s stock market that is based in countries that are not considered “developed.” These categories of developed and emerging are open to interpretation. Is South Korea an emerging market? In some indices it is; in others, it is considered developed. If you buy a pair of funds that will cover the developed and emerging markets, you will want to attend to the index that is followed, and make sure there isn’t any overlap. FP Canada uses the MSCI Emerging Markets Index as the base index for this projection, so it should be compatible with the MSCI EAFE index which is a component of the Foreign Developed category.
Because inflation has been very much part of the conversation in the last year or so, I should note that FP Canada has kept its long-term inflation projections at 2.1%. While that may seem much too low given what we have been experiencing, I do not think it is unreasonable to expect that inflation will revert to the Bank of Canada target.
How to Proceed?
Given these figures, one might be tempted to put everything into the category that is projected to have the best long-term return, that is, Emerging Markets Equities. Personally, I would be reluctant. Because volatility, especially if it veers into negative territory, can be so corrosive to returns, diversifying your assets broadly among the categories is probably the more reasonable approach. This will tend to smooth out portfolio returns and give you a chance to rebalance back into your long-term strategy.
“Don’t put all your eggs in one basket” remains as true for investing as it does on the farm. Remember, the stock market is bigger than Canadian dividend payers!
This is the 195th blog post for Russ Writes, first published on 2023-05-01
Click here to contact me for an appointment.
You may be interested in a half-hour no-cost, no-obligation financial planning conversation with me. Click here to sign up for a free session of FinPlan30.
Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.