How do you estimate investment returns?

One of the important challenges in retirement planning is deciding what values to use for the expected returns of stocks and bonds. Everyone likes to talk about investment returns, so these numbers are likely going to capture the interest of clients. That means you’d better ensure your numbers are reasonable.

In a recent white paper co-authored with Raymond Kerzérho, my colleague and Director of Research at PWL Capital, we laid out our firm’s methodology for estimating future returns for stocks and bonds. In a nutshell, we look at both long-term history and current valuations and take the average of the two.

For example, our long-term expectation for stocks in developed countries is a 7% nominal return (a 5% real return plus 2% expected inflation). However, based on current valuations (using the Shiller CAPE ratio as of May), expected returns on U.S. stocks are now only about 6.1%, while those for international equities are 7.9%. When we create financial plans, we use an average of these long-term and current figures; in this case, 6.6% for U.S. equities and 7.5% for international.

Our logic is that both methods have flaws, but when one overestimates expected returns, the other will likely underestimate them by a similar amount. Bonds offer a good example today. Our long-term expectation is 4.7%, but this seems too optimistic in an era when the benchmark index is yielding 2.6%. Yet assuming bonds will continue to yield just 2.6% for 20 or more years seems unnecessarily conservative. An average of these two estimates (3.7%) is a reasonable compromise.

The desire for precision

When we released our white paper to the public (and indeed, any time we discuss expected returns with clients) the reaction was interesting. Many investors clearly have a strong desire for precision: they want to know how these return rates will affect their portfolio’s final value even if that’s a decade or two in the future. Many ask for the portfolio’s estimated value at the end of each year so they can use them as milestones. And they want to know how their financial prospects would change if we tweaked the numbers by a fraction of a point.

This is understandable, of course. After all, we’re talking about people’s retirement savings, and everyone wants to know if they’ll have enough. But it’s important for both planners and their clients to understand the limitations of these estimates:

• They tell you absolutely nothing about short-term returns. Expected returns are used for long-term planning only: no methodology can help you predict what your portfolio will return next year. No one should use these planning assumptions to make tactical plays by overweighting or underweighting specific asset classes.
• Returns are never slow and steady. One might expect stocks to return 7% over 20 years, but that annualized return will almost surely include many years of double-digit annual gains and many others with significant losses. Here’s a shocking finding: a portfolio with equal amounts of Canadian, U.S. and international equities would have posted annual returns between 6% and 11% just five times from 1970 through 2013. Meanwhile, returns would have been negative 11 times, and over 15% in 21 of those 44 years.*
• Expected returns are moving targets, not point forecasts. Financial plans need to be reviewed every year or two, and if there have been significant changes in market conditions (such as a big move in interest rates or a bear market in stocks) then the expected returns should be updated. There is no “set it and forget it” in financial planning.

*Based on the performance of the S&P/TSX Composite, the S&P 500 and the MSCI EAFE indexes from 1970 through 2013. All returns in Canadian dollars.