PWL publishes monthly Market Statistics which is an invaluable tool in our work with clients. By reviewing what the marketplace has done over a given period of time, we can anticipate how a client's portfolio has performed, in general terms. For example, the December Market Stats tell us that fixed income (bonds) and REITs had positive returns in 2011. Our clients all hold some bonds and generally hold Canadian REITs. Therefore, there should be a positive return on these portions of their portfolios.
We also see that longer term bonds, at an annual return of 9.67%, provided a higher total return (interest plus capital appreciation) than shorter term bonds at 4.65%. The "flight to safety" we saw in 2011, as investors left the equity markets in favour of government bonds, drove the price of those bonds up, resulting in higher return and making bonds, particularly government bonds, expensive to add to a portfolio now. We chose to keep our fixed income allocations in shorter term bonds - when interest rates do increase, we anticipate that bond prices will go down, and that there will be more volatility with longer term bonds. We are risk managers and would rather direct risk on the equity side, using the fixed income portion to maintain stability in the portfolio.
On the equity side, we see that small stocks produced a slightly higher return in 2011 than the “market” in Canada (-7.85% for the TSX Mid and Small Cap and -8.71% for the TSX Composite), but not in the US (-1.93% for the Russell 2000 in C$ vs. 4.51% for the S&P 500 in C$) or Internationally (-13.57% for the MSCI EAFE Small Cap in C$ vs. -9.66% for the MSCI EAFE in C$). In relation to value stocks, we see the value premium did not show in the US (1.85% vs. 4.51%), and only slightly on the International side (-9.57% vs. -9.66%). We expect the small and value premium to show itself over the long term, but know it will not appear every year. We saw the small cap premium in all markets in 2010, and a slight value premium in the US, but not Internationally. For 2011, we can conclude that clients who had small and value tilts on the equity portion of their portfolios will have performance below the "market" when measured against an index with no tilts.
The concept of which benchmark should be used for comparison of relative performance is a topic for another day. Suffice it to say that, for purposes of our meetings with clients, we use our Market Stats as a basis for a discussion on the reasons for both under and over performance, thus helping our clients manage their expectations and avoid common behaviour traps.
With RRSP season upon us, we are being bombarded with advertising and newspaper articles on the importance of saving for our retirement. Savings become investments and investments must be monitored and measured in relation to an individual’s financial plan.
One of the most important investment measurements is performance. An article by Jonathan Chevreau caught my eye recently – “RRSPs – get a handle on risk”. In conjunction with a blog by Larry Swedroe - “Of Course My Returns Beat the Market” - the theme of performance started coming through. Chevreau talks about the importance of having an idea of the return required to make your retirement a reality. And the importance of knowing what return you actually receive is reinforced in Swedroe's blog.
If you don't know what return you need, how can you work with your advisor (or dare I say, with yourself if you claim to be a DIY investor), to build a portfolio that is right for you, and your risk tolerance? And then if you don't know whether you are meeting your target returns how will you know whether you are on track? It's like being on a road trip where you know your destination but have no idea how to get there.
We talk about investing within your risk tolerance. One important point to note is that this can apply to taking on too little or too much risk. If a financial plan works with a target return of, say 4%, and a Monte Carlo or other “what if” analysis shows a very high probability of success, should the client take on more risk than necessary? Conversely, if the plan requires a 7% return to succeed and the client has a low risk tolerance, how can the portfolio be adequately structured? A higher equity allocation may cause so much anxiety in volatile times that classic behavioural mistakes result. A re-evaluation of basic planning assumptions may be more appropriate - maybe those extra travel dollars in the early years of retirement can be pared back.
The importance of having a plan and reviewing it regularly can't be stressed enough. After the downturn in 2008, we updated our clients' retirement projections to reflect the impact of lower portfolio values, and lower expected returns going forward. Since then, we have compared actual to projected at the end of each year. In general, our portfolios did not meet the target 4% return in 2011. But the fact that we had higher than target in the past two years means that, on a cumulative basis, we are still on track.
We know the target return will not be achieved every year, but by keeping an eye on where we planned to be versus where we are, at least we have a chance to keep our perspective when we have an "off" year. Having a plan helps to set expectations and therefore helps to manage our behaviour around our money.