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Rule of Thumb: What is a realistic rate of return for my portfolio?

October 3, 2011 - 1 comment

When meeting with prospects, I still observe unrealistic portfolio return expectations (i.e. a 12% rate of return expectation for a balanced portfolio without much risk). By gaining a better sense of the risk premiums investors have demanded in the past, we are able to gain more insight on reasonable assumptions for constructing portfolios to meet our financial goals. Elroy Dimson, Paul Marsh and Mike Staunton have completed extensive research on historical asset class returns from a global perspective. In the Credit Suisse Global Investment Returns Yearbook 2009, Dimson, Marsh and Staunton illustrate a build-up approach to expected portfolio returns, which I have adapted and summarized in the chart and commentary below:  

Source: PWL Capital Inc. – adapted from Credit Suisse Global Investment Returns Yearbook 2009, Dimson, Marsh and Staunton

 

The expected inflation rate
To estimate the long-term rate of inflation, a Canadian investor could either use the Bank of Canada’s target inflation rate of 2.0%, or the current difference in the long-term Government of Canada benchmark bond yield (2.84% as of September 29, 2011) and the long-term real return bond yield (0.88% as of September 29, 2011). This alternative method would imply a long-term inflation rate expectation of approximately 1.96%.

The estimated real return on treasury bills (cash)
While it is impossible to know what the real return will be on cash going forward, for the sake of simplicity, we’ll use 1.0% (the annualized real return of US government treasury bills between 1900 and 2008).

The estimated maturity premium
Dimson, Marsh, and Staunton estimate the projected maturity premium for bonds (relative to treasury bills) going forward to be 1.0%. The average maturity premium on the World index (in USD) was 0.8% between 1900 and 2008, with bond returns exhibiting greater volatility (and higher returns) in the post-1950 period than before (1.2% compared to 0.3%). They therefore argue that a slightly higher premium than the historical average should be expected in the future. 

The estimated equity premium
Between 1900 and 2008, the trio’s research found that the world global equity premium (relative to treasury bills) was 4.2%. After adjusting for historical factors that they believe are non-repeatable, they argue that an annualized equity premium of approximately 3.5% is a more likely expectation going forward.

The estimated small-cap and value premiums
Over the longest available time periods, the average annualized premiums (relative to the market) for investing in smaller companies and value companies was approximately 1.0% to 1.5%. They argue that by placing a 50% value or small cap “tilt” on the equity portion of your portfolio, you can increase the expected equity return by approximately 0.5% to 0.75% per year. For portfolios which include both a small-cap and value tilt (similar to most PWL portfolios), we’ll assume an additional 1.0% estimated premium, relative to a market portfolio.

By combining the nominal expected rates of return for equities and bonds (6.5% and 4.0% respectively), we are able to calculate expected portfolio rates of return for various asset allocations that can be used as a guideline for constructing a portfolio that suits an investors’ requirements.

Note: The grey columns use 6.5% as the expected equity return while the blue columns use 7.5% as the expected small-cap/value tilt equity return. All columns use 4.0% as the expected bond return.

So are you still expecting 10% returns from your investments?
As can be seen in the simplified analysis above, the expected rates of return using this approach may be lower than many investors would like to believe, especially after subtracting fees from the returns. More importantly, financial planners using more than a 4.0% to 5.0% rate of return for their projections (after fees) may be overstating the return that their clients can reasonably expect on their investable assets.

Source: Bank of Canada, Credit Suisse Global Investment Returns Yearbook 2009, Dimson, Marsh and Staunton
 


 

 

By: Justin Bender with 1 comments.
Comments
  03/10/2011 1:57:39 PM
Rob Steele
Very interesting analysis Justin. It would be interesting to see the same work done using central bank rates vs inflation assumptions as the 'starting point'. Clearly, as we've seen over the past couple of years, inflation rates become moot when the central banks artificially cap interest rates. Thanks!
 



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