I Dream I’m on Vacation……

ROI Definition

In his song “Life’s Been Good”, Joe Walsh of the Eagles says “I dream I’m on vacation ’cause I like the way that sounds, it’s the perfect occupation for me….”. If this summer’s hot weather in Ontario had you dreaming about being on “vacation” seven days a week, the Fall is a great time to refocus and check your progress towards creating a Worry Free Retirement Experience™.

Let’s state the obvious. There are only two ways to accumulate the money you need to be financially independent — by how much you save, and by the rate of return that you earn on your savings. Ogden Nash, the poet and humorist, once said “If you don’t want to work you have to work to earn enough money so that you won’t have to work”. That’s the saving part. Let’s discuss the latter – investment returns – and specifically, what is a realistic return on your investments in today’s economic environment.

How often have you been in a group of people at a party, and there was one person in the crowd who claimed she earned 10% “last year” – a period when you know that markets globally went through a very rough patch. At first you think, maybe it was the wine. Could she really have earned 10% last year?

Then it starts to weigh on your mind. Likely you’re either envious, in which case you immediately contact your own advisor. Or alternatively, you’re skeptical, so you write off the partygoer as a blowhard. But later while reflecting on this, you ask yourself, “what IS a realistic investment return in today’s markets”. 10%?, 2%?, 5%?, 12%? You know you have a diversified portfolio, but what return is both reasonable and realistic?

How about 3-5%? No way, you say! Brace yourself because it probably IS realistic. Here’s why. Let’s say you have 50% of your money in stocks and the remaining 50% in bonds. Assume that the 50% equity component averages 7.06% which was the return of the S&P/TSX for the 15 years ending July 31, 2016 (Source: GlobeInvestor.com), or maybe even 8.04% which is the 20-year figure. Equities would therefore contribute 3.5% to 4% (50% X 7 or 8) to what we term the “weighted” return of your portfolio.

Do the same calculation for the bond component, but let’s assume that based on today’s interest rates which are historically very low – and in some countries, negative – your professionally managed bonds deliver a 3% return. (Arguably, this could be 2-5%, but let’s stay with 3% for our purposes). With 50% of your investment in bonds, they contribute 1.5% to the weighted return of your portfolio. So overall, a realistic or reasonable expected return on the 50/50 diversified portfolio is 5% to 5.5% (3.5% to 4% on equities plus 1.5% on bonds).

Some years that return will be higher, and some years it will be negative. But, our message is that it’s important to be realistic in planning for the long term. If your advisor is showing you a plan with an 8% long term portfolio return, he or she isn’t doing you any favours! Question it.

Use the simple method above to estimate the expected return on your portfolio. Granted it includes “assumptions”, but keep those assumptions conservative, bearing in mind that a person who “retires” at age 65 could still have 1/3 of his/her lifetime ahead.

Costs matter. The cost of actually earning that weighted return cannot be ignored. Consider a portfolio of equities and bonds invested in a 50/50 mix and held in mutual funds and ETFs (Exchange Traded Funds). Let’s say that the equity component is an equal mix of Canada, U.S., and International stocks. We’ll use historical performance data for the various equity indices going back to the beginning of 1978 until December 2015. And, we’ll stick with 3% for bonds. We’ll also assume that your advisor charges a competitive 1 to 1.25% per annum for financial planning and investment management for portfolios under $1 million, and that the overall Management Expense Ratio (MER) of the mutual funds and ETFs in the portfolio – the cost of managing the investment that is built into the investment – is 0.52% per annum. (Total cost 1.77% per annum, less than most “balanced” mutual funds, but more than a portfolio of ETFs only).

By running thousands of computer simulations factoring in costs and and possible variations in market performance, we can determine that your actual return – net of fees – would be more like 3.25% to 3.50%. So there you have it. You won’t be the life of the party if you stand on the coffee table and proclaim, “I got 3.5% last year!”, but you might just win the prize as the most realistic investor.

Watch for our upcoming blog which discusses “the path to a better investment experience”.